houman b. shadab* - university of pennsylvania law school · innovation and corporate governance:...

INNOVATION AND CORPORATE GOVERNANCE:THE IMPACT OF SARBANES-OXLEY

Houman B. Shadab*

In 2006, Apple began shipping certain Mac computers withoutinforming customers that the computers were equipped with the latestinnovation in wireless technology, the 802.11 n wireless card. Later, Applerevealed that these computers were enabled to use the wireless card, butthat customers would have to pay $1.99 to download software to activatethe technology. In response to customer demands for an explanation, anApple spokesperson explained that, due to accounting rules mandated byfederal corporate governance law, the company was required to charge anominal fee for the software because it had already recognized revenue onthe computers when they first began to ship.' This incident demonstratesthat there is a subtle yet powerful relationship between innovation andcorporate governance. This Article examines that relationship.

Analysis of the relationship between innovation and corporategovernance is timely, as scholars and policymakers continue to debate theimpact of the corporate governance changes brought about by theSarbanes-Oxley Act of 2002 ("SOX").2 In response to several corporate

* Senior Research Fellow, Regulatory Studies Program, Mercatus Center at George

Mason University. B.A. 1998, University of California at Berkeley; J.D. 2002, Universityof Southern California. I would like to thank Jerry Ellig, Peter G. Klein, Brian BrenbergJennifer Zambone, and Anthony Skriba for invaluable comments, and Patrick Manchesterand Christopher White for research assistance. All errors are my own. The author can bereached at [email protected].

1. Jacqui Cheng, Apple Confirms 802.1 In Fee, But for Less Than Expected, INFINITELoop, Jan. 18, 2007, http://arstechnica.com/journals/apple.ars/2007/1/18/6679; Tom Krazit,Apple's 802.11n Accounting Conundrum, CNETNEWS.COM, Jan. 19, 2007,http://www.news.corn/Apples-802.11 n-accounting-conundrum/2100-1044_3-6151790.html.

2. See, e.g., LUIGI ZINGALES ET AL., INTERIM REPORT OF THE COMMITTEE ON CAPITAL

MARKETS REGULATION 29-39, 131-34 *2006), available athttp://crapo.senate.gov/documents/committee-capmarkets-reg.pdf (finding that U.S. capitalmarkets have become less competitive post-SOX and recommending reforms to reduce thecosts of SOX's internal control provisions); Christian Leuz, Was the Sarbanes-Oxley Act of2002 Really this Costly? A Discussion of Evidence from Event Returns and Going-PrivateDecisions, 44 J. ACCT. & ECON. 146 (2007) (reviewing studies finding that SOX imposessubstantial costs on public companies and arguing that such costs may not be attributable toSOX and therefore that the conclusions of the studies are premature); Kate Litvak,

956 U. PA. JOURNAL OF BUSINESS AND EMPLOYMENT LAW [Vol. 10:4

governance failures in 2001 and 2002, Congress enacted SOX to reducemanagement's ability to abuse accounting rules or otherwise actopportunistically at the expense of investors. SOX increases monitoringover corporate executives, requires more extensive internal control overfinancial reporting, and stiffens civil and criminal penalties for fraud andother violations of the federal securities laws.3 This Article finds that, bytilting corporate governance toward more objective monitoring by outsidersand thereby restricting subjective decision making by insiders, SOX likelyreduces the innovative potential of a significant portion of publiccompanies, and this, in turn, may impose a cost on society in the form offoregone benefits from innovation.

Previous evaluations of SOX have not addressed the law's impact oninnovation as undertaken by established public corporations. To the extentthat other studies have focused on SOX's impact on innovation, theyexamined SOX's potential to undermine the growth of small,entrepreneurial companies by raising the barriers to access public capitalmarkets.4 This is in part because corporate governance scholarship rarelyanalyzes innovation.' By first examining the relationship betweeninnovation and corporate governance, this Article provides new insightsabout the impact of SOX on innovation.6

Innovation is a process that results in new products, methods of

Sarbanes-Oxley and the Cross-Listing Premium, 105 MICH. L. REV. 1857, 1860-61 (2007)(finding that in the year SOX was passed the relatively higher price of foreign companyshares that are subject to U.S. regulation through cross-listing decreased); Robert A.Prentice & David B. Spence, Sarbanes-Oxl as Quack Corporate Governance: How Wise isthe Received Wisdom?, 95 GEO. L.J. 1843 (2007) (arguing that early criticisms of SOX aremisguided and that SOX may have provided benefits); N. K. Chidambaran et al., DoesBetter Corporate Governance "Cause" Better Firm Performance? 6 (March 2007)(unpublished research paper, on file with Rutgers Business School), available athttp://www.isb.edu/SummerResearchConference/Chidambaran.pdf (finding uniformcorporate governance reforms of the type mandated by SOX likely made investors in somecompanies worse off).

3. See infra notes 136-152 and accompanying text.4. See, e.g., Lynn Stephens & Robert G. Schwartz, The Chilling Effect of Sarbanes-

Oxley: Myth or Reality?, CPA J., June 2006, at 14 (reporting on SOX's impact on 108entrepreneurial technology companies).

5. See Marcela Miozzo & Paul Dewick, Building Competitive Advantage: Innovationand Corporate Governance in European Construction, 31 RES. POL'Y 989, 990 (2002)("Research on the relationship between corporate governance and the process of innovationhas been limited to date because the main theories of corporate governance do not integratesystematically an analysis of the economics of innovation.").

6. As noted by a January 2008 advisory committee report to the U.S. Secretary ofCommerce, research on the relationship between SOX and innovation is lacking. THEADVISORY COMMITTEE ON MEASURING INNOVATION IN THE 21ST CENTURY ECONOMY,

INNOVATION MEASUREMENT: TRACKING THE STATE OF INNOVATION IN THE AMERICAN

ECONOMY 12 (2008), available at http://www.innovationmetrics.gov/Innovation%20Measurement%2001-08%20rev%20040908.pdf.

INNOVATION AND CORPORATE GOVERNANCE

production, and forms of business organization. Innovation can vastlyimprove the welfare of consumers, investors, firms, and the economy.Consumers are better off when innovation results in higher quality goodsand services or entirely new methods of production and distribution. In2006 alone, a record 182,000 new consumer products were introducedglobally.' Investors also benefit when successful innovation increases theprice of their shares. Companies perform better when they successfullyinnovate, contributing to the health of the economy and raising standards ofliving.8 Yet, innovation is not without risk. Overspending on research anddevelopment ("R&D"), for example, can destroy value to the detriment ofemployees and investors. A short-term gain from innovation may besquandered if it is mismanaged or quickly copied by rivals.9 Nonetheless,given the widespread economic benefits derived from innovation, SOX'simpact on innovation by public companies is a cause for concern.

To understand the relationship between innovation and corporategovernance, Part I examines the defining characteristics of innovation as itis undertaken by established corporations. Innovation is ultimately theproduct of new knowledge and arises in response to economic change.Corporate entrepreneurship activities, such as strategic renewal, whichenable companies to innovate the way they are organized, also facilitateinnovation. Innovation requires companies to commit to long-term riskyactivities and coordinate the activities of employees throughout theorganization.

Based upon the characteristics of innovation and innovative firms,Part II finds that governance structures, such as decentralization and anemphasis on strategic internal control, facilitate innovation. The ultimatepurpose of such innovation-facilitating structures is to prevent managersfrom focusing too much on relatively short-term and more readily-quantifiable performance measures (myopia) and instead undertake thelong-term, risky, dynamic, and knowledge-intensive activities that result ininnovation. Innovation-facilitating structures and activities may, however,also increase the ability of managers to benefit themselves at the expense of

7. Press Release, Mintel International Group, Record-Breaking Number of NewProducts Flood Global CPG Shelves (Jan. 23, 2007), available athttp://www.mintel.com/press-release.php?id=254053.

8. See Bart Verspagen, Innovation and Economic Growth, in THE OXFORD HANDBOOK

OF INNOVATION 487 (Jan Fagerberg et al. eds., 2005) (reviewing the literature on therelationship between economic growth and innovation).

9. See CLAYTON M. CHRISTENSEN, THE INNOVATOR'S DILEMMA 111-256 (CollinsBusiness Essential 2005) (1997); see also William Lazonick, The Theory of the InnovativeEnterprise 3 (INSEAD, Working Paper No. 200 1/15/SM), available athttp://ged.insead.edu/fichiersti/inseadwp2001/2001-15.pdf (finding that innovations mayplace innovating firms at a cost disadvantage relative to rivals because "innovative strategiestend to entail higher fixed costs than the fixed costs incurred by [non-innovating] rivals").

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the company. Value-maximizing companies must therefore successfullynegotiate the tradeoffs between reducing myopia and preventingmanagerial opportunism.

Part III examines how the structures mandated by SOX impact thistradeoff. SOX requires all public companies to increase objectivemonitoring of managers by outsiders to reduce opportunism. A substantialportion of innovative companies, however, maximize value by placing agreater emphasis on proximate monitoring by insiders than SOX permits.The law thus upsets the optimal governance balance in such companies,and likely undermines their ability to provide the most value to investorsand consumers. In sum, innovation has specific characteristics which giverise to an important governance tradeoff, and SOX likely impacts thistradeoff to the detriment of innovation.

I. THE CHARACTERISTICS OF CORPORATE INNOVATION

Economic innovation is a process that ultimately results in somethingnew and valuable to consumers. Successful innovation generally consistsof discovering a new idea, developing it through a project, and thencommercializing the idea for profit.' ° Innovations include not only newproducts for consumers (i.e., goods and services), but also new methods ofproduction and new forms of organization within firms. " Innovations may

10. See Jan Fagerberg, Innovation: A Guide to the Literature, in THE OXFORDHANDBOOK OF INNOVATION, supra note 8, at 4 ("Invention is the first occurrence of an ideafor a new product or process, while innovation is the first attempt to carry it out intopractice."); Federico Munari & Maurizio Sobrero, Corporate Governance and Innovation,in CORPORATE GOVERNANCE, MARKET STRUCTURE AND INNOVATION 3 (Mario Calderini etal. eds., 2003) (stating that innovation begins "with the generation of new knowledgetargeted to the discovery of new products and processes, and ending with their commercialexploitation"); Barry Jaruzelski et al., Smart Spenders: The Global Innovation 1000,STRATEGY & Bus., Dec. 14, 2006, at 1, 4 ("[H]igh-leverage innovators and the companieswith best overall performance distinguish themselves not by the money they spend, but bythe capabilities they demonstrate in ideation, project selection, development, orcommercialization"); Elizabeth Shaw et al., Corporate Entrepreneurship and InnovationPart 2: A Role- and Processed-Based Approach, 8 EUR. J. INNOVATION MGMT. 393, 395(2005) (stating that innovation involves an idea discovery phase and a commercializationphase).

11. See ISRAEL M. KIRZNER, DISCOVERY AND THE CAPITALIST PROCESS 85 (1985)("Innovative activity consists in the creation . . . of an output, method of production, ororganization not hitherto in use.") (emphasis in original); MARY O'SULLIVAN, CONTESTS FORCORPORATE CONTROL: CORPORATE GOVERNANCE AND ECONOMIC PERFORMANCE IN THEUNITED STATES AND GERMANY 12 (2000) (finding that innovation generates "higher qualityand/or lower-cost products"); JOSEPH A. SCHUMPETER, THE THEORY OF ECONOMICDEVELOPMENT: AN INQUIRY INTO PROFITS, CAPITAL, CREDIT, INTEREST, AND THE BUSINESSCYCLE 66 (Redvers Opie trans., Transaction Publishers 1983) (1934) (noting that innovationconsists of new goods, new methods of production, exploitation of new markets and sourcesof supply, and new forms of organization).


entail incremental improvements to existing goods and methods ofproduction, or radically new products, processes, and organizationalforms. 12 However, innovation does not include mere changes in thequantity of production or the location of transactions to more efficientlymeet consumer demand, unless some new underlying product, process, orform is involved.

A. Innovation and Knowledge

At its most basic level, a business firm is a collection of productiveassets.13 Assets are inputs used to produce goods and services. 14 Assetsinclude physical goods such as inventory, buildings, and human capital, aswell as intangibles such as knowledge and organizational advantages.' 5

Assets become productive when employed in regularized productionroutines. 16 The combination of assets, activities, and routines within a firmgives rise to capabilities, which permit the achievement of particularoutcomes through coordinating activities. 17

Innovation is a capability that enables a firm to create something new,and it is heavily dependent upon the utilization of intangible knowledgeassets. 18 Innovation stems from learning-generating new knowledge by

12. Astrid H. Lassen et al., The Nexus of Corporate Entrepreneurship and RadicalInnovation, 15 CREATIVITY & INNOVATION MGMT. 359, 360 (2006).

13. This view of the business firm stems from a resource-based approach to the firm.See EDITH TILTON PENROSE, THE THEORY OF THE GROWTH OF THE FIRM 24 (1959)(explaining that the firm is "a collection of productive resources the disposal of whichbetween different uses and over time is determined by administrative decision"); KathleenM. Eisenhardt & Jeffrey A. Martin, Dynamic Capabilities: What Are They?, 21 STRATEGICMGMT. J. 1105, 1105 (2000) (noting that the resource-based view of the firm "assumes thatfirms can be conceptualized as bundles of resources, that those resources areheterogeneously distributed across firms, and that resource differences persist over time").

14. Steven E. Phelan & Peter Lewin, Arriving at a Strategic Theory of the Firm, 2 INT'LJ. MGMT. REVIEWS 305, 312 (2000) (noting that under the Penrosian resource-based view ofthe firm, "[r]esources are defined as inputs into the firm's operations that are used toproduce products or services").

15. Eisenhardt & Martin, supra note 13, at 1106-1107 (defining "resources" to includephysical, human and organizational assets).

16. A routine is a "regular and predictable behavioral patterns of firms." RICHARD R.NELSON & SIDNEY G. WINTER, AN EVOLUTIONARY THEORY OF ECONOMIC CHANGE 14(1982).

17. See Phelan & Lewin, supra note 14, at 312 ("A capability (or competency) is theability to perform a task or activity that involves complex patterns of co-ordination and co-operation between people and other resources" and includes "research and development,excellent customer service and high quality manufacturing.").

18. Roger J. Calantone et al., Learning Orientation, Firm Innovation Capability, andFirm Performance, 31 INDUSTRIAL MARKETING MGMT. 515, 515-18 (2002) (reviewingliterature on organizational learning and innovation); Benn Lawson & Danny Samson,Developing Innovation Capability in Organisations: A Dynamic Capabilities Approach, 5

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building upon existing knowledge.' 9 Innovation occurs when a firm"transform[s] knowledge and ideas into new products, processes andsystems for the benefit of the firm and its stakeholders. 2 ° Much of theknowledge from which innovation stems is tacit and "local," meaning thatsuch knowledge is unique to the company and the environment in whichthe knowledge arises. 2 A successful innovation capability builds upon theknowledge within the company to integrate new products or methods intothe firm's existing production and marketing capabilities. In addition, the"absorptive capacity" of a firm to integrate external knowledge is crucialfor successful innovation.2 2 Ultimately, successfully leveraging andmanaging new knowledge through innovation improves firm performanceto the benefit of investors and consumers.2 3

INT'L J. INNOVATION MGMT. 377, 382 (2001) (noting that leading innovators "[link]organisational learning and knowledge" to production and view innovation "as a mechanismfor creating new knowledge").

19. See MARIO MORRONI, KNOWLEDGE, SCALE AND TRANSACTIONS IN THE THEORY OFTHE FIRM 233 (2006) ("Innovative activity can be regarded as a learning process.");O'SULLIVAN, supra note 11, at 12-14 (characterizing innovation as a cumulative learningprocess based upon the existing "'common stock' of knowledge"); Shaw et al., supra note10, at 396 ("[Clreativity assists in the emergence of new and novel ideas that will initiateand support the innovation process .... Existing knowledge is important because, in orderto be creative, innovators must go beyond the established status quo .... "); Shaker A. Zahraet al., Entrepreneurship and Dynamic Capabilities: A Review, Model and ResearchAgenda, 43 J. MGMT. STUD. 917, 932 (2006) (explaining that innovative "learning ...depends on what [firms] already know").

20. See Lawson & Samson, supra note 18, at 384.21. See Jackie Kraffl & Jaques-Laurent Ravix, The Governance of Innovative Firms:

An Evolutionary Perspective, 14 ECON. INNOVATION & NEW TECH. 125, 135 (2005)("Innovative firms develop specific production plans and are mainly endowed with local,private and tacit knowledge."); Keith Pavitt, Innovation Processes, in THE OXFORDHANDBOOK OF INNOVATION, supra note 8, at 88 (noting that some of the knowledge learnedin the innovation process is firm-specific).

22. See Wesley M. Cohen & Daniel Levinthal, Absorptive Capacity: A NewPerspective on Learning and Innovation, 35 ADMIN. SCI. Q. 128, 128 (1990); TunjiAdegbesan & Joan E. Ricart, What Do We Really Know About When TechnologicalInnovation Improves Performance (and When it Does Not)? 12-13 (IESE Bus. Sch., Univ.of Navarra, Working Paper No. 668, 2007) ("[I]nnovativeness is dependent on a firm'sability to leverage external knowledge, integrating it with its internal knowledge sources").

23. See William C. Bogner & Pratima Bansal, Knowledge Management as the Basis ofSustained High Performance, 44 J. MGMT. STUD. 165, 169-72, 181-83 (2007) (discussingthe importance of new knowledge creation and continued development for firmperformance); see also Jaruzelski et al., supra note 10, at 11-12 (finding that "high-leverage" innovators obtain more value from R&D spending and outperform rivals byintegrating all stages of the innovation process).


B. Adapting to and Creating Economic Change

A business earns profits by generating revenues in excess of costs. 24

As economic change takes place over time, a firm's revenues and costs alsochange.25 To the extent that economic change leads to higher costs orlower revenues, firms must adapt their activities or suffer losses or lowerprofits.26 For example, a higher quality product by a competitor may resultin lost business and require the company to produce a better product or facelower sales. When economic change necessitates developing new productsor production methods, innovation is required.27 Innovation may be aresponse to changes from within the firm (e.g., employee demographics) orfrom changes external to the firm (e.g., consumer preferences, prices ofinputs, the conduct of competitors, or the opening of new markets).2"

As the pace of economic change and competitive pressures increase,innovation becomes a necessary "cost of doing business."2 9 The incentive

24. A basic starting point for standard microeconomics is that firms attempt tomaximize profits by maximizing total revenues and minimizing total costs, requiring a firmto produce a level of output such that marginal revenue equals marginal cost. See ROBERT

COOTER & THOMAS ULEN, LAW AND ECONOMICS 30-31 (4th ed. 2003).25. See Mark Casson, Entrepreneurship and the Theory of the Firm, 58 J. ECON.

BEHAV. & ORG. 327, 333 (2005) (noting that some economic changes "are demand-relatedand impact mainly on a firm's revenues, while others are supply-related and mainly affect afirm's costs") (emphasis in original).

26. Total profits equals total revenues minus total costs, therefore a decrease inrevenues or increase in costs will lead to lower profits. See F. A. Hayek, The Use ofKnowledge in Society, 35 AM. ECON. REV. 519, 523 (1945) ("[E]conomic problems arisealways and only in consequence of change. So long as things continue as before, or at leastas they were expected to, there arise no new problems requiring a decision, no need to forma new plan."); Theodore W. Schultz, The Value of the Ability to Deal with Disequilibria, 13J. ECON. LIT. 827, 827 (1975) ("No matter what part of a modem economy is beinginvestigated, we observe that many people are consciously reallocating their resources inresponse to changes in economic conditions.").

27. See Lawson & Samson, supra note 18, at 378 (noting that innovation is "requiredfor adapting to changing markets, technologies and modes of competition."); Shaw et al.,supra note 10, at 394 (noting that change is among the "key precipitating environmentalfactors for innovation").

28. See PETER F. DRUCKER, INNOVATION AND ENTREPRENEURSHIP: PRACTICE AND

PRINCIPLES 35 (1985) (outlining seven sources of innovation, including sources originatingfrom within the enterprise); Donald F. Kuratko & Michael H. Morris, CorporateEntrepreneurship: The Dynamic Strategy for 21st Century Organizations, in ISSUES IN

ENTREPRENEURSHIP: CONTRACTS, CORPORATE CHARACTERISTICS AND COUNTRY

DIFFERENCES, 2002 21, 28-30 (Gary D. Libecap ed., 2003) (noting both external and internaldrivers of entrepreneurial activity in corporations); Casson, supra note 25, at 332-34(introducing a typology of sources of economic volatility).

29. See Richard N. Langlois, Transaction-Cost Economics in Real Time, 1 INDUS. &CORP. CHANGE 99 (1992) (noting that as "firms and markets learn" there arises a "kind ofinformation or knowledge cost-the cost of transferring the firm's capability to the marketor vice versa").

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to stay ahead of competition and preserve profits will induce an establishedfirm to innovate when the established firm's "failure to develop theinnovation means that new entrants almost certainly will." 30 Accordingly,a firm may need to adopt innovation routines and make innovation a part ofits overall strategy for dealing with change.3'

In addition, firms can increase profits by using innovation toproactively exploit change or create change. Proactive innovation "consists

in the purposeful and organized search for changes, and in the systematic

analysis of the opportunities such changes might offer for economic or

social innovation. 3 2 Indeed, proactively exploiting change for profit

constitutes the "overwhelming majority of successful innovations., 33 Even

where there is little or no change, innovators can introduce change to the

economy by creating higher quality or lower cost products or methods.

This process often leads to fundamental changes in industries and the

economy, and was famously characterized by economist Joseph

Schumpeter as "creative destruction. 34 The capability of a firn to createchange through innovation, like any other productive asset, is a source ofvalue to the business and its shareholders. For this reason, successfulinnovation results in better economic performance,35 thereby makinginvestors better off.

30. DAVID BESANKO ET AL., ECONOMICS OF STRATEGY 437 (4th ed. 2007).31. NELSON & WINTER, supra note 16, at 128-34; see Lassen et al., supra note 12, at

366 (explaining that the "flexibility" required for innovation entails "the ability toincorporate change as a continuous consideration in the organization" such that change "isperceived as a natural process"); James P. Andrew et al., Innovation 2007: A BCGManagement Survey 20 (2007), available at http://www.bcg.ch/fileadmin/media/pdf/innovation..2007.pdf (noting that successful innovators "have seeminglyinstitutionalized the ability to innovate"); see also Kuratko & Morris, supra note 28 at 25("[I]nnovation is the key to developing and successfully exploiting competitiveadvantages."); Lawson & Samson, supra note 18, at 381 (noting that as the result of changesin the marketplace "[i]nnovation represents today's competitive advantage").

32. DRUCKER, supra note 28, at 35; see also Lassen et al., supra note 12, at 361, 363-67, 368 (explaining that a fundamental aspect of innovation is being proactive throughanticipating and pursuing new opportunities).

33. DRUCKER, supra note 28, at 35; see also Lawson & Samson, supra note 18, at 386(discussing Cisco as an example of a company which employs strategies to use innovationproactively, as opposed to reactively; such companies are more successful).

34. JOSEPH A. SCHUMPETER, CAPITALISM, SOCIALISM AND DEMOCRACY 81-86 (3rd ed.1975) (1942).

35. RONALD S. JONASH & TOM SOMMERLATTE, THE INNOVATION PREMIUM: How NEXT

GENERATION COMPANIES ARE ACHIEVING PEAK PERFORMANCE AND PROFITABILITY 5-7(1999); Leslie H. Vincent et al., Does Innovation Mediate Firm Performance? A Meta-Analysis of Determinants and Consequences of Organizational Innovation 18 (2004),available at https://www.smartech.gatech.edu/handle/1853/10731.


C. Long-Term Risk-Taking

Compared to other types of investment projects undertaken bycorporations, innovation projects tend to be riskier and require longer-termcommitments.36 Innovation, by definition, involves something new andunknown and therefore requires a firm to undertake R&D or other projectswith a high degree of uncertainty regarding their outcomes. 37 Furthermore,substantial long-term investments are so important to successful innovationthat unsuccessful innovation may result simply from the failure to commitsufficient assets for a long enough period.38 Successful commercializationof particular innovations can be a process lasting several years and mayrequire sacrificing short-term profits to gain from more important sourcesof company value in the long-term.39

Long-term innovation investments require employees to "commit theirskills and efforts to the pursuit of the goals of the enterprise rather thanselling their human capital on the open market., 40 Commitment by topmanagement, in particular, helps ensure successful radical innovationbecause top managers are the principle instigators of long-term, strategicdecision-making. 41 Financial commitment is also often a precondition tosuccessful completion of a long-term innovation project. 4' Financial

36. Bengt Holmstrom, Agency Costs and Innovation, 12 J. ECON. BEHAV. & ORG. 305,309 (1989).

37. Mary O'Sullivan, Finance and Innovation, in THE OXFORD HANDBOOK OFINNOVATION, supra note 8, at 257-58; Pavitt, in THE OXFORD HANDBOOK OF INNOVATION,supra note 8, at 88 ("Innovation is inherently uncertain, given the impossibility of predictingaccurately the cost and performance of a new artifact, and the reaction of users to it.").

38. O'SULLIVAN, supra note 11, at 20 ("[A] failure to generate returns at any point in[the innovation process] may be a manifestation not of a failed innovative strategy, but ofthe need to commit even more resources to an ongoing learning process."); Lawson &Samson, supra note 18, at 381 (noting that "innovation is a force of instability, oftenrequiring long-term vision and commitment to yield results").

39. See, e.g., BESANKO et al., supra note 30, at 430 (noting that "JVC-Matsushita'ssuccess in the VCR business was shaped by decisions and commitments that those firmsmade 15 to 20 years before VCRs became commercially viable."); Mike Rogoway, MagicInside: Intel's Breakthrough, OREGONIAN, July 15, 2007 (reporting that Intel began work in2003 on a microprocessor innovation that was completed in 2007), available athttp://blog.oregonlive.com/oregonianextra/2008/04/the-oregonians-pulitzer.-prize.htm;Andrew et al., supra note 31, at 22 (noting that a managerial survey respondent attributedToyota's success in innovation to its "willing[ness] to forgo today's profit in order todominate the market later on").

40. O'SULLIVAN, supra note 11, at 60.41. See Lassen et al., supra note 12, at 368 (arguing that top management commitment

is a determining factor in entrepreneurial success); see also infra note 67 and accompanyingtext (arguing the necessity of management approval in entrepreneurial corporate exercises).

42. See O'SULLIVAN, supra note 11, at 60 (explaining that financial institutions must"support the ongoing access of a business organization to the financial resources required toundertake and sustain the development and utilization of productive resources until such a

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commitment allows firms to capture revenues generated by innovation andcontinue to innovate over time.43 In addition, a corporate culture thattolerates failure and rewards long-term success can promote innovation bypreventing individuals from abandoning projects before they arecompleted."

D. Corporate Entrepreneurship and Strategic Decision-Making

Entrepreneurship is an essential and fundamental aspect of innovation.Accordingly, the relationship between corporate governance and corporateentrepreneurship sheds much light on the relationship between governanceand innovation. 45 Entrepreneurship means to discover and utilize neweconomic opportunities. 46 Entrepreneurship and innovation are closelyrelated, but not synonymous, concepts. While exploiting a new opportunitymay result in the creation of new products, production methods ororganizational forms (innovative entrepreneurship), it may also involve

activities that do not result in innovation, such as selling existing goods in a

new market (non-innovative entrepreneurship). In this sense, innovation is

a subcategory of entrepreneurship. 47 Therefore, innovation by public

companies occurs when corporate entrepreneurs produce new goods or

implement new production methods and forms of organization.

Corporate entrepreneurship has the same general features as

entrepreneurship practiced by individuals or by small, new firms.

time as these resources can generate returns").43. Id. ("Only through continued investment can the depreciation or obsolescence of

existing productive resources-skills, knowledge, and physical assets-be counterbalancedby the development of new skills, knowledge, and physical resources in order to sustain the

competitive advantage of the learning collectivity.").44. See infra note 54 (discussing the importance of corporate culture).45. Modem legal scholarship has generally paid little attention to entrepreneurship

theory. For a notable exception, see D. Gordon Smith & Masako Ueda, Law andEntrepreneurship: Do Courts Matter?, 2 ENTREPRENEURIAL Bus. L.J. 353 (2006) (arguing

that common law systems revise their legal rules so as to promote capital formation andentrepreneurship by new firms).

46. See Scott Shane & S. Venkataraman, The Promise of Entrepreneurship as a Field ofResearch, 25 ACAD. MGMT. REV. 217, 218 (2000) (noting that entrepreneurship researchinvolves "the study of sources of [economic] opportunities; the processes of discovery,

evaluation, and exploitation of opportunities, and the set of individuals who discover,evaluate, and exploit them.") (emphasis in original); see also Casson, supra note 25, at 329(finding "judgmental decision-making" to be the defining attribute of entrepreneurship inthe classic economic literature on the topic). Entrepreneurship is understood in different

ways by scholars, business professionals and policymakers, and entrepreneurship researchoften reflects the varied approaches to entrepreneurship.

47. Lassen et al., supra note 12, at 360-61; see also Kuratko & Morris, supra note 28, at25 ("[E]ntrepreneurship captures the full set of [opportunity pursuing] actions the firm takesto create, renew, or innovate ....").


However, it also has unique aspects due to the special structure and legaltreatment of corporations under U.S. law. There are two unique aspects ofcorporate entrepreneurship relevant to corporate governance: the role ofthe board of directors in facilitating organizational change and the role ofupper-level managers as entrepreneurial strategists. It should be noted thatalthough entrepreneurship is often regarded by policymakers and the publicas solely the domain of new business ventures (start-ups), large, well-established firms such as corporations also practice entrepreneurship.48

Indeed, because of their superior access to resources, managerial skill, anddistribution networks, established corporations are often more effectivethan small start-ups in exploiting new opportunities.49

Entrepreneurial corporations are those that discover, create, andexploit economic opportunities5 ° Corporate entrepreneurship requiresdecision makers to exercise judgment over how corporate resources shouldbe used in the face of uncertainty and how incentives should be structuredto make managers and other employees more likely to discover and actupon entrepreneurial opportunities.5 1 Corporate entrepreneurship oftenleads to innovation52 and requires the corporate entrepreneur to "assess newopportunities" and "align and exploit resources" to further innovation. 3

Innovation and corporate entrepreneurship are encouraged by a corporateculture where top management supports innovative activities; does notmicromanage investment projects; makes resources available to manager-entrepreneurs; and tolerates, encourages, and rewards risk-taking andfailure."

48. See, e.g, DRUCKER, supra note 28, at 21-22 (noting that entrepreneurship requires afirm to be more than just new and small, and identifying specific examples of largeentrepreneurial firms); Shane & Venkataraman, supra note 46, at 219 ("[E]ntrepreneurshipdoes not require, but can include, the creation of new organizations .... ").

49. DRUCKER, supra note 28, at 144; see also Peter F. Drucker, Foreword to VIJAYSATHE, CORPORATE ENTREPRENEURSHIP: TOP MANAGERS AND NEW BUSINESS CREATION xi("The great majority of new businesses during the last decades of the twentieth century...were created and built by existing enterprises, and in large part by big or at least fair-sizedones .... ).

50. See Shane & Venkataraman, supra note 46, at 218.51. See Nicolai J. Foss & Peter G. Klein, Entrepreneurship and the Economic Theory of

the Firm: Any Gains from Trade?, in HANDBOOK OF ENTREPRENEURSHIP RESEARCH 55, 63(2005) (explaining the exercise of entrepreneurial judgment in a firm setting).

52. See Kuratko & Morris, supra note 28, at 26 ("Corporate entrepreneurship representsa framework for the facilitation of ongoing change and innovation in establishedorganizations.").

53. Shaw et al., supra note 10, at 394.54. See SATHE, supra note 49, at 20-24 (showing that corporate entrepreneurship is

promoted when resources are sufficiently available, managers do not perceive a personalrisk in doing so and are not micromanaged); Jeffrey S. Hornsby et al., Middle Managers'Perception of the Internal Environment for Corporate Entrepreneurship: Assessing aMeasurement Scale, 17 J. BUS. VENTURING 253, 256, 266-69 (2002) (arguing that corporate

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The board of directors is the modem corporation's principalgovernance mechanism, enabling numerous interests and dispersedinformation to be coordinated and processed among corporate actors.55

The three primary functions of a board are to monitor and hold topmanagement accountable, to be indirectly involved in operational decisionmaking (such as providing advice to top managers and setting broadcorporate policies), and to provide a network of contacts to thecorporation.56 Directors delegate their decision making authority andcontrol to top managers who, in turn, delegate their own decision making tosubordinate managers and employees.57 Just as all persons "can onlygather so much information from so many inputs before beingoverloaded,"5 8 corporate entrepreneurs, in particular, have limited attentionspans they are able to devote to innovation as opposed to maintainingexisting production routines.s9 Delegated decision making facilitates

innovation by helping to ensure that corporate entrepreneurs can devote

sufficient time to innovation projects and not be distracted by otherconcerns.

60

Strategic decision making is an important activity that furthersinnovation. Strategic decision making means adopting "commitments,decisions, and actions designed and executed to produce a competitiveadvantage and earn above-average returns" on investment. 6' Whereasstrategic management focuses on more mundane goals such as monitoringproduction routines for efficiency, strategic entrepreneurship focuses on

entrepreneurship in pursuit of innovation is promoted by top management support ofinnovative activities, managerial autonomy, reward/incentive systems, availability ofresources and a clear understanding of job duties); Lassen et al., supra note 12, at 361, 363-67, 368-69 (stating that flexibility and openness to change facilitate proactiveness and risk-taking which further the development of substantial innovations); Lawson & Samson, supranote 18, at 389-90 (noting that tolerance of ambiguity, empowered employees, time forcreativity and communication are elements of a corporate culture supporting innovation);Andrew et al., supra note 31, at 10-11 (finding that top-level executives consider a risk-averse corporate culture to be the most significant obstacle to innovation).

55. Stephen M. Bainbridge, Director Primacy: The Means and Ends of CorporateGovernance, 97 Nw. U. L. REV. 547, 557-60, 573-74, 599-600 (2003)

56. See id. at 599; Lynne L. Dallas, The Multiple Roles of Corporate Boards ofDirectors, 40 SAN DIEGO L. REV. 781, 801-07 (2003).

57. Stephen M. Bainbridge, Why A Board? Group Decisionmaking in CorporateGovernance, 55 VAND. L. REV. 1, 4-5 (2002).

58. Id. at 6.59. Sharon Gifford, The Economics of Limited Entrepreneurial Attention, in 11 THE

SOURCES OF ENTREPRENEURIAL ACTIVITY 123, 125-26 (Gary D. Libecap ed., 1999).60. See Bainbridge, supra note 57, at 6 n.19 (noting that delegated decision making

through "branching hierarchies" efficiently limits the information to which corporatesupervisors are exposed).

61. Michael A. Hitt et al., Strategic Entrepreneurship: Entrepreneurial Strategies forWealth Creation, 22 STRATEGIC MGMT. J. 479, 480 (2001).


discovering and utilizing new opportunities.62 The strategy of aninnovative corporation is to determine how to invest and develop assets toproduce new products and methods to outcompete rivals. 63 To achieveinnovation, strategic decisions should also foster long-term commitmentsor else "interest and attention become too dispersed." 64 Strategicinnovation requires a company to fundamentally re-conceptualize itsexisting business routines "to achieve dramatic value improvements forcustomers and high growth" for itself.65 For example, in the mid 1990sGeneral Motors went beyond selling automobiles to also sell informationservices through a hands-free on-board communications system calledOnStar.

66

Top managers are the decision makers primarily responsible forstrategic decision making and entrepreneurship. 67 However, the board ofdirectors also can play a role in strategy through strategic renewal, strategicmonitoring and, in certain cases, direct involvement in strategicmanagement. Strategic renewal is a process of internal change andreorganization that results in organizational innovation.68 Organizationalinnovation is important for established companies because, relative to smallor new firms, established firms have well-developed production routines.Innovative public corporations need to be sufficiently flexible to changeroutines because often "[t]he ability of an organization to innovate is a

62. Id. at 480-81; see Kuratko & Morris, supra note 28, at 26-28 (noting that corporateentrepreneurship may be a component of a firm's strategic decisions with respect to rivals);Steven Michael et al., Discovery and Coordination in Strategic Management andEntrepreneurship, in STRATEGIC ENTREPRENEURSHIP: CREATING A NEW MINDSET 44(Michael A. Hitt et al. eds., 2002) (noting that entrepreneurial management "focuses onidentifying opportunity and mobilizing resources to take the firm in new directions with newcapabilities, products, or markets"); R. Duane Ireland et al., A Model of StrategicEntrepreneurship: The Construct and its Dimensions, 29 J. MGMT. 963, 983 (2003) (notingthat strategic entrepreneurship involves opportunity- and advantage-seeking behavior).

63. See Lazonick, supra note 9, at 3-4, 10 (discussing the importance of innovation).64. Lawson & Samson, supra note 18, at 389.65. Bodo B. Schlegelmilch et al., Strategic Innovation: The Construct, its Drivers and

its Strategic Outcomes, 11 J. STRATEGIC MARKETING 117, 118 (2007).66. VIJAY GOVINDARAJAN & CHRIS TRIMBLE, TEN RULES FOR STRATEGIC INNOVATORS:

FROM IDEA TO EXECUTION xviii (2005).67. Donald F. Kuratko et al., Corporate Entrepreneurship Behavior Among Managers:

A Review of Theory, Research, and Practice, in CORPORATE ENTREPRENEURSHIP 7, 10(Jerome A. Katz & Dean A. Sheperd eds., 2004); Zahra et al., supra note 19, at 944.

68. See Donald F. Kuratko et al., A Model Of Middle Level Managers' EntrepreneurialBehavior, 29 ENTREPRENEURSHIP THEORY & PRAC. 699, 701 (2005) (analyzing thetransformation of ongoing organizations through strategic renewal); Shaker A. Zahra,Governance, Ownership, and Corporate Entrepreneurship: The Moderating Impact ofIndustry Technological Opportunities, 39 ACAD. MGMT. J. 1713, 1715 (1996) (noting thatcorporate entrepreneurship includes strategic renewal activities such as "revitalizing thecompany's operations by changing the scope of its business" and "building or acquiring newcapabilities and then creatively leveraging them to add value for shareholders").

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precondition for the successful utilization of inventive resources or newtechnologies."69 For example, in the late 1980's, Samsung became aleading innovator in computer memory chips, but would not have been ableto do so without first decentralizing its operations and consolidating certainbusiness units. 7

A board is more likely to play a significant role in strategic renewalwhen a company is undertaking substantial structural changes and isoperating in a relatively uncertain economic environment. 7' Boards alsooften engage in strategic monitoring, which includes evaluatingmanagement's strategic choices after they are made and making broadrecommendations regarding strategy. 72 Boards rarely exercise a direct rolein strategic management. This is likely because outside directors acting ina direct strategic capacity may harm performance with contributions thatare redundant, based on knowledge inferior to that of managers, or ininterference with the board's and management's other functions.7 3

E. Innovation and the Established Corporation

Established corporations possess inherent advantages anddisadvantages over other types of organizations in creating and utilizinginnovations. Established firms' advantages include possession ofcomplementary production and marketing resources, access to internalcapital, routines for innovation, and economies of scope and scale.74 Onthe other hand, corporate innovation is "path dependent," meaning that itscourse is constrained by prior commitments and established routines. 75

Established firms that have already invested in a particular product or

organizational capability may be reluctant to switch to a new technology

69. See Alice Lam, Organizational Innovation, in THE OXFORD HANDBOOK OF

INNOVATION, supra note 8, at 115.70. BESANKO ETAL., supra note 30, at 531.71. Kevin Hendry & Geoffrey C. Kiel, The Role of the Board in Firm Strategy:

Integrating Agency and Organisational Control Perspectives, 12 CORP. GOVERNANCE 500,510 (2004) (noting that the strategic role of the board "help[s] an organization adapt toenvironmental change" and that environmental uncertainty likely leads to directors assertingmore strategic control).

72. Dallas, supra note 56, at 807-08.73. See id. The relationship between outside directors and innovation is explored in

detail in infra Part III.C.74. See Scott Shane & Riitta Katila, When Are New Firms More Innovative Than

Established Firms? 3 (2003) (unpublished article, on file with the Robert H. Smith Schoolof Business) (reviewing the economics literature identifying reasons why established firmsmay be more innovation than new firms).

75. BESANKO ET AL., supra note 30, at 443-45; see also Zahra et al., supra note 19, at932 ("[L]eaming is a path dependent process wherein what firms learn depends on whatthey already know.").


for fear of taking away profits from their current products and lowering thevalue of resources used to make those products.76 For example, from 2005to 2006, Motorola allocated too many resources to maintaining its popularRAZR cell phone and not enough to developing the next generation ofphones to stay ahead of competitors." Larger firms may also suffer fromorganizational inertia and have trouble adapting to change. 8 In particular,large established firms often have trouble integrating new products withestablished routines and structures. 9 In a 2007 survey of approximately2,500 top-level managers around the world, failing to implement aninnovation project quickly enough was identified as one of the mostsignificant barriers to successful innovation.8° Effective innovation thusrequires strategic renewal and other forms of adaptation and flexibility inorder to properly and timely incorporate new processes and products.8'

When an established corporation undertakes innovation successfully,it is generally an organization-wide effort. While certain aspects of theprocess, such as R&D or product development, may be segregated intodiscrete units and operated by actors not involved in other aspects of thecompany's operations,8 2 corporate assets involved in the innovationprocess encompass numerous aspects of a company's operations and

76. BESANKO ET AL., supra note 30, at 436.77. Christopher Rhoads & Li Yuan, How Motorola Fell a Giant Step Behind-As it

Milked Thin Phone, Rivals Sneaked Ahead on the Next Generation, WALL ST. J., April 27,2007, at Al.

78. Michael T. Hannan & John Freeman, Structural Inertia and OrganizationalChange, 49 AM. Soc. REV. 149, 149 (1984); see also Holmstrom, supra note 36, at 306(finding that "the large corporation has emerged primarily to serve production andmarketing goals and that in pursuing those objectives effectively it has to organize in a waythat compromises innovation incentives"); Jesper B. Sorensen & Toby E. Stuart, Aging,Obsolescence, and Organizational Innovation, 45 ADMIN. SCI. Q. 81 (2000) (describing theeffects of "aging" on innovation).

79. See Deborah Dougherty & Trudy Heller, The Illegitimacy of Successful ProductInnovation in Established Firms, 5 ORG. Sci. 200, 214 (1994) (finding that a commonbarrier to innovation exists where "the constituent activities of new product development donotfit into, or are not a part of, the legitimate system of thought and action in multiple, ifsubtle, ways") (emphasis in original); Wim Vanhaverbeke & Nico Peeters, EmbracingInnovation as Strategy: Corporate Venturing, Competence Building and CorporateStrategy Making, 14 CREATIVITY & INNOVATION MGMT. 246, 247 (2005) (explaining thatlarge firms must develop new capabilities to capitalize on new products or technologies).

80. Andrew et al., supra note 31, at 10-11, 17-19.81. Nils Stieglitz & Klaus Heine, Innovations and the Role of Complementarities in a

Strategic Theory of the Firm, 28 STRATEGIC MGMT. J. 1, 5 (2007); David J. Teece et al.,Dynamic Capabilities and Strategic Management, 18 STRATEGIC MGMT. J. 509, 515 (1997).

82. See Phillipe Aghion & Jean Tirole, The Management ofInnovation, 109 Q. J. ECON.1185, 1206 (1994) ("[W]hen intellectual inputs dominate as for software and biotechnology,research will often be performed by independent units .... "); see also DRUCKER, supra note28, at 174 (stating that innovative firms should not "put the entrepreneurial into the existingmanagerial component .... [Nor] make innovation an objective for people charged withrunning, exploiting, optimizing what already exists").

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governance structure. In the context of an established corporation,innovation is

a set of interwoven processes... [that] are multiple, overlappingand performed by a multitude of different actors inside andoutside companies, with a distribution of actions and decisionmaking at different organizational levels . . . related both tohigher-level structural organizational arrangements, and to lower-level microbehavioural attainments.83

Accordingly, the activities of the researchers, directors, managers, andadvertisers required to successfully complete an innovation project areinterdependent.14 Learning and communicating the new knowledge neededfor innovation requires coordinating the activities within a company. 5 Forexample, when BMW begins to develop a new model automobile,employees from departments as diverse as engineering, design, marketing,purchasing, and finance are brought together to a centralized location tofacilitate coordination of their activities. 86

II. INNOVATION AND CORPORATE GOVERNANCE

Because innovation requires coordination of activities on a company-wide basis, it is affected by corporate governance structures and policiesapplicable to the entire organization.87 Based upon the defining

83. Munari & Sobrero, supra note 10, at 3-4; see also Deborah Dougherty & CynthiaHardy, Sustained Product Innovation in Large, Mature Organizations: OvercomingInnovation-to-Organization Problems, 39 ACAD. MGMT. J. 1120, 1123 (1996) ("Eachinnovation project also needs administrative structures and processes appropriate to itsdevelopment stage and access to decision making across the organization.").

84. See Jan Fagerberg, Innovation: A Guide to the Literature, in THE OXFORD

HANDBOOK OF INNOVATION, supra note 8, at 13 (describing innovation as a systemic processcomprised of "a set of activities (or actors) that are interlinked"); Keith Pavitt, InnovationProcesses, in THE OXFORD HANDBOOK OF INNOVATION, supra note 8, at 88 (describinginnovation within large corporations as a series of several overlapping processes); Stieglitz& Heine, supra note 81, at 5 (explaining that "individual learning processes [involved withinnovation] are themselves interdependent and require coordination").

85. See O'SULLIVAN, supra note 11, at 14-17 (observing that working with other peoplecreates new opportunities to learn outside an individual's personal work and experience);Shaw et al., supra note 10, at 400 (observing that social interaction is necessary for theeffective exchange of resources and information).

86. Special Report: The World's Most Innovative Companies, BUSiNESSWEEK, April24, 2006, available at http://www.businessweek.com/magazine/content/0617/b3981401 .htm.

87. See Langlois, supra note 29, at 106 (1992) ("How the firm is organized-how theroutines of the humans and machines are linked together-is also part of a firm'scapabilities. Indeed, 'skills, organization, and "technology" are intimately intertwined in afunctioning routine, and it is difficult to say exactly where one aspect ends and anotherbegins."').


characteristics of innovation and how innovation is practiced bycorporations, this Part identifies the types of governance structures thatsupport innovation. Generally, structures that support innovation aredesigned to prevent managers from acting myopically to achieve short-termoutcomes with relatively low risk. However, innovation-facilitatinggovernance structures may also allow managers to act opportunistically andbenefit themselves at the expense of investors. To maximize shareholdervalue while facilitating innovation, a company must choose the rightbalance between employing outside monitors to reduce opportunism andutilizing proximate monitors to reduce myopia.

A. Governance Structures and Shareholder Value

Corporate governance consists of the rules, entities, and processes thatgovern how corporations use their assets to generate and distributerevenues among shareholders, employees, and other parties.88 A primarytype of governance structure comes from corporate law, which consists of:"Off-the-rack" state statutes giving rise to the unique corporate form;employment and compensation contracts, corporate charters, and by-laws;regulations, such as those mandating disclosure to publicly raise capital;and the holdings of court decisions defining the meaning of such rules andestablishing fiduciary and other duties among the relevant parties. 89

Monitoring and disciplining entities is also a type of governance structure,both internal to the corporation (such as the board of directors) and externalto it (such as federal regulators, auditors, and securities analysts). A thirdtype of structure arises from competitive processes such as the market forcorporate control, which constrains and alters the behavior of directors andmanagers through mechanisms such as hostile takeovers and proxycontests. The ultimate goal of any system of corporate governance is tomaximize the wealth of stockholders. 90

88. See O'SULLIVAN, supra note 11, at I ("[A] system of corporate governance shapeswho makes investment decisions in corporations, what types of investments they make, andhow returns from investments are distributed.").

89. See, e.g., Gillian Hadfiled & Eric Talley, On Public Versus Private Provision ofCorporate Law, 22 J.L. ECON. & ORG. 414, 416-17 (2006) (describing the types of servicesthat constitute "corporate law"); Roberta Romano, Corporate Law and CorporateGovernance, 5 INDUS. & CORP. CHANGE 277, 277-78 (1996) (explaining that corporategovernance institutions are "established or policed by corporate law .... [A]s the legalregime sets the parameters for all corporate governance mechanisms").

90. Bainbridge, supra note 55, at 574-84; see also Katz v. Oak Indus. Inc., 508 A.2d873, 879 (Del. Ch. 1986) ("It is the obligation of directors to attempt, within the law, tomaximize the long-run interests of the corporation's stockholders."); Henry Hansmann &Reinier Kraakman, The End of History for Corporate Law, 89 GEO. L.J. 439, 441 (2001)(describing the scholarly consensus that "the best means to this end (that is, the pursuit ofaggregate social welfare) is to make corporate managers strongly accountable to shareholder

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In the United States, significant aspects of corporate law are"enabling" as opposed to mandatory, meaning that corporations may

choose their own governance structures from a default set of rules provided

by state incorporation statutes. 91 In practice, corporations avail themselves

of this ability by adopting a variety of different governance mechanisms.

Transaction cost economics provides a basic rationale for the diversity in

governance structures-those structures aligned with transaction-specificcharacteristics have performance advantages over less well-aligned

structures. 92 Transaction cost economics identifies the important

characteristics of transactions, how those characteristics give rise to

particular types of transaction costs, and then identifies what governance

structure reduces the costs of undertaking transactions and increasesproductive output.

93

The alignment of governance structures with transactions based upon

their specific characteristics also holds at the firm level. The empirical

corporate governance literature largely finds that a corporation's choice of

governance structure is a result of its firm-specific characteristics. In other

words, governance mechanisms are endogenously determined by firm

attributes.9 4 Furthermore, companies generally choose structures that

interests and, at least in direct terms, only to those interests"); Jean Tirole, CorporateGovernance, 69 ECONOMETRICA 1, 1 (2001) ("The standard definition of corporategovernance among economists and legal scholars refers to the defense of shareholders'interests."); Sanjai Bhagat & Roberta Romano, Empirical Studies of Corporate Law 3 (Eur.Corp. Gov. Inst., Working Paper No. 44/2005, 2005) ("[T]he benchmark for evaluating thebenefit of corporate and securities laws is whether they improve investor welfare.").

91. FRANK H. EASTERBROOK & DANIEL R. FISCHEL, THE ECONOMIC STRUCTURE OF

CORPORATE LAW 2-3 (Harvard University Press 1996) (1991) (observing that in almostevery state the corporate code acts as an enabling statute).

92. See Robert J. David & Shin-Kap Han, A Systematic Assessment of the EmpiricalSupport for Transaction Cost Economics, 25 STRATEGIC MGMT. J. 39, 40 (2004) (noting thatthe central claim of transaction cost economics is "that transactions will be handled in sucha way as to minimize the costs involved in carrying them out"); Oliver E. Williamson,Strategizing, Economizing, and Economic Organization, 12 STRATEGIC. MGMT. J. 75, 79

(1991) (identifying the main task of the transaction cost theory of the firm as "align[ing]transactions, which differ in their attributes, with governance structures, which differ in theircosts and competencies, in a discriminating (mainly, transaction cost economizing) way").

93. David & Han, supra note 92, at 40-41.94. See Chidambaran et al., supra note 2, at 28-29 (concluding from the impact of

changes in governance structures on firm value that "firms are endogenously optimizingtheir governance structure in response to observable and unobservable firm characteristics");James S. Linck et al., The Determinants of Board Structure, 87 J. FIN. ECON. 308, 309(2008) (finding that "firms structure their boards in ways consistent with the costs andbenefits of monitoring and advising by the board," which varies across different types offirms); M. Babajide Wintoki et al., Endogeneity and the Dynamics of Corporate Governance4-6 (Oct. 11, 2007) (unpublished research paper, on file with University of Georgia, TerryCollege of Business), available at http://papers.ssrn.com/sol3/papers.cfm?abstractid=970986 (finding no significant relationship between boardcomposition, board size, board leadership, insider ownership and firm performance). But


maximize overall firm value, as opposed to choosing structures that benefitmanagers or some other corporate constituency. 95 Accordingly, there is noset of "good" governance structures that can be universally adopted tomake investors in firms with different characteristics better off.96 Becauseinnovative firms often share similar characteristics, they adopt similargovernance mechanisms to facilitate innovation.

B. Governance Structures Supporting Innovation

Because a firm's choice of governance devices is in large part aresponse to transaction- or firm-specific characteristics, the economiccharacteristics of innovation and of innovative firms provide insight as towhat structures facilitate (or undermine) innovation. Furthermore, becausecorporations generally choose governance structures in order to maximizeperformance (and hence, value to shareholders), the governance devicesadopted by firms that successfully innovate provide insight into howinnovation should be governed. Based upon the characteristics ofinnovation identified in Part I, as well as a large body of literatureanalyzing the characteristics of successful innovative firms, twofundamental structures that facilitate innovation can be identified: (1)decentralization which facilitates the generation and communication ofknowledge, and affords companies the flexibility required to adapt tochange; and (2) an emphasis on strategic internal control which promoteslong-term risk-taking.

see Reena Aggarwal & Rohan Williamson, Did New Regulations Target the RelevantCorporate Governance Attributes?, 24, 28-29 (April 14, 2006) (unpublished research paper,on file with Georgetown University, McDonough School of Business), available athttp://papers.ssrn.com/sol3/papers.cfm?abstractid=891411 (finding that governancestructures and firm value are not endogenously determined).

95. See Audra L. Boone et al., The Determinants of Corporate Board Size andComposition: An Empirical Analysis, 85 J. FIN. ECON. 66, 69 (2007) (finding results which"indicate that board size and composition vary across firms and change over time toaccommodate the specific growth, monitoring, and managerial characteristics of the firm");Chidambaran et al., supra note 2, at 34-36; Linck et al., supra note 94, at 309 (finding theresults of testing what firm-specific attributes are correlated with what board structures to be"generally consistent with efficiency explanations of the determinants of board structure");Wintoki, supra note 94, at 4-6 (finding no significant relationship between boardcomposition, board size, board leadership, insider ownership and firm performance).

96. See J. Harold Mulherin, Corporations, Collective Action and CorporateGovernance: One Size Does Not Fit All, 124 PUB. CHOICE 179, 199 (2005) ("The centralpolicy implication of the prior research and new supporting evidence is that one size doesnot fit all in corporate governance"); Chidambaran et al., supra note 2, at 5-6 (finding thatgood and bad changes in governance structures lead to both positive and negativeperformance changes, no differences in performance between firms that have good or badchanges, and that corporations with good governance do not outperform those with worsegovernance).

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As a matter of first principle, because innovation is dependent uponthe proper utilization of tacit and particularized knowledge, 97 innovationrequires corporate activities to be organized so that knowledge is generatedand communicated to the appropriate decision makers."5 Companiesshould thus be structured to decrease the costs of generating knowledge andcommunicating it within the firm. 99 Furthermore, governance devicesshould also create opportunities and incentives to learn, communicate, andallocate decision making to those directors or managers with theknowledge most relevant for a given task.'00 When economic activitydepends upon the generation and communication of tacit or firm-specificknowledge, outside monitoring and centralized decision-making aregenerally of limited value. This is because tacit and particularizedknowledge is costly to communicate, especially to those lacking familiaritywith the context in which the knowledge arose. 101

Accordingly, knowledge-generation and communication tend tobenefit from the adoption of decentralized governance structures, or those

97. See supra Part I.A.98. See O'SULLIVAN, supra note 11, at 20-21, 22-23, 36-37 (explaining the importance

of organization to utilizing the knowledge involved with innovation); trica Gorga &Michael Halberstam, Knowledge Inputs, Legal Institutions and Firm Structure: Towards aKnowledge-Based Theory of the Firm, 101 Nw. U. L. REV. 1123, 1127 (2007) (noting thattwo functions served by economic organization are the production of knowledge andcommunication or "diffusion" of that knowledge).

99. See Nicolai J. Foss, The Emerging Knowledge Governance Approach: Challengesand Characteristics, 14 ORG. 29, 45 (2007) ("As a practical and normative enterprise,knowledge governance means deploying governance mechanismses [sic] that mitigate thecosts of sharing, integrating and creating knowledge .... ).

100. See Nicola Lacetera, Corporate Governance and the Governance of Innovation:The Case of Pharmaceutical Industry, 5 J. MGMT. & GOVERNANCE 29, 38 (2001)(explaining that to support innovation "decision-makers should have appropriateinformation about [a] firm's operations" and incentives should be in place so persons shareknowledge and competencies).

101. See NELSON & WINTER, supra note 16, at 125 (noting the "severe limits onarticulation [in the case] of organizational knowledge"); Walter W. Powell & Stine Grodal,Networks of Innovators, in THE OXFORD HANDBOOK OF INNOVATION, supra note 8, at 76(noting that the type of knowledge typically leading to innovation is "very 'sticky' andcontains a large tacit component [such that] the degree of difficulty and the costs of transferare high"); Foss, supra note 99, at 46 (noting that because of the tacit nature of muchknowledge, "delegation of the right to initiate, carry out, etc. knowledge sharing withcolleagues seems to be an efficient alternative to instructing employees to share specificknowledge" through a centralized decision-making mechanism); see also Milton Harris &Artur Raviv, A Theory of Board Control and Size, REV. FIN. STuD. 33-35 (forthcoming2008) (showing that insider control of boards is optimal when knowledge possessed byinsiders is beyond a threshold level of importance beyond knowledge possessed byoutsiders); Charu G. Raheja, Determinants of Board Size and Composition: A Theory ofCorporate Boards, 40 J. FIN. & QUANT. ANALYSIS 283, 285 (2005) (showing that theoptimal number of outsiders on the board decreases as monitoring or "verification" costsincrease).


structures giving corporate agents, such as managers and their subordinates,more discretion.'0 2 An essential component of decentralization in thecorporate context consists of allocating decision making authority toinsiders who have superior knowledge about the company and itsenvironment.' °3 Innovation is thus furthered when "the allocation ofcorporate resources and returns is in the hands of decision-makers who areintegrated with the learning process that generates innovation."'10 4 Forexample, innovative companies seem to benefit from having a relativelyhigh proportion of board members that are also company insiders (i.e.,employees). 105

Decentralized governance facilitates not only knowledge-utilization,but also the type of organizational flexibility that innovation requires. 106 Inadapting to ongoing economic change, a "manager must be endowed withsufficient elements of discretion in order to organize the coordination ofinnovative investments."' 1

07 In particular, changing and adapting

organizational structures requires that managers have "control and decisionrights over the firm's assets, including the rights to redefine and reallocatespecific use and decision rights."'0 8 In other words, substantial managerialdiscretion facilitates strategic renewal and organizational innovation.'09 In

102. See Nicolai J. Foss & Keld Laursen, Performance Pay, Delegation and MultitaksingUnder Uncertainty and Innovativeness: An Empirical Investigation, 58 J. ECON. BEHAV. &ORG. 246, 264-65 (2005) (finding that employees often have greater authority delegated tothem and are less restricted in their activities in dynamic and innovative environments);Robert M. Grant, Toward A Knowledge-Based Theory of the Firm, 17 STRATEGIC MGMT. J.109, 119 (1996) ("The principle of co-location requires that decisions based upon such tacitand idiosyncratic knowledge are decentralized, while decisions requiring statisticalknowledge are centralized."); Jack A. Nickerson & Todd R. Zenger, A Knowledge-BasedTheory of the Firm-The Problem-Solving Perspective, 15 ORG. Scl. 617, 626 (2004)(arguing that decentralized consensus-based hierarchy "achieves extensive knowledgetransfer by enhancing the efficiency with which knowledge transfer occurs among actorswithin the firm"); Joseph E. Stiglitz, Public Policy for a Knowledge Economy 3, 19 (Jan. 27,1999) (unpublished article, on file with World Bank) ("In the firm, moving from simplerepetitive work under central control (Taylorism) to more complex knowledge-based workrequires a move towards a more decentralized and participative workplace.").

103. See MICHAEL C. JENSEN & WILLIAM H. MECKLING, FOUNDATIONS OFORGANIZATIONAL STRATEGY 106 (1998) ("When knowledge is valuable in decision making,there are benefits to colocating decision authority with the knowledge that is valuable tothose decisions.").

104. O'SULLIVAN, supra note 11, at 60.105. See infra Part III.C.106. Teece et al., supra note 81, at 515.107. Krafft & Ravix, supra note 21, at 140.108. Stieglitz & Heine, supra note 81, at 7.109. See id. at 7-8 (noting that "[i]f general management is not permitted to change

organizational structures and experiment with new ways of doing things, the development ofnew corporate assets may be seriously hampered"); Zahra et al., supra note 19, at 941, 950(arguing that established firms change their existing capabilities through planned changewhich in turn enables strategic renewal).

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addition, managerial discretion facilitates integration of new products andprocesses with established routines, especially when major innovationsrequire a company to make a significant change in organizational structureor change how production processes are carried out." l In sum,decentralization helps companies to utilize knowledge, adapt to andpromote economic change, engage in strategic renewal, and integrate newproducts into existing routines.

In addition to facilitating the utilization of knowledge to promoteinnovation, governance must encourage commitment to long-term risk-taking. The most straightforward governance devices facilitating long-terminnovation activities are compensation contracts giving managers monetaryincentives to take long-term risks. "' Incentive compensation in the form ofstock, stock options, or bonuses tied to longer-term measures ofperformance can successfully promote long-term risk-taking." 2 However,compensation schemes with the goal of promoting innovation areinherently limited. Because innovation is a long-term and organization-wide process often involving numerous persons, it is difficult to measure anindividual's precise contribution to innovation and hence compensate themappropriately." 3 Furthermore, compensation schemes use financialindicators of success and therefore may lead managers to focus on more

110. See Stieglitz & Heine, supra note 81, at 6 (arguing that formal organizationalstructures are less important for integrating more substantial "modular" and "radical"innovations, and that management needs substantial control to change organizationalstructures); Teece et al., supra note 81, at 521 (noting that decentralization and localautonomy assist the processes of "reconfiguration and transformation"); see also Dougherty& Hardy, supra note 83, at 1121-22 (noting that successful innovation requires connectinginnovations with existing routine operations).

111. See O'SULLIVAN, supra note 11, at 60 ("[Tlhe prospects of sharing in the gains ofsuccessful innovation by the investing organization can lead even mobile participants toforgo the lure of the market and remain committed to the pursuit of organizational goals.");Lawson & Samson, supra note 18, at 382 ("Leading innovators encourage, expect andreward innovation from everywhere within the organisation .... "); Stieglitz & Heine, supranote 81, at 6-7 (finding that incentive to invest in innovative assets is greater when thedecision-maker owns the assets); see also Andrew Tylecote & Paulina Ramirez, CorporateGovernance and Innovation: The U.K. Compared with the US. and "Insider" Economies,35 REs. POL'Y 160, 162 (2006) (arguing that innovation is facilitated when corporategovernance enables the firm to appropriate returns).

112. See Vincent L. Barker III & George C. Mueller, CEO Characteristics and FirmR&D Spending, 48 MGMT. Sci. 782, 793 (2002) (finding that "greater stock ownership bythe CEO was associated with higher R&D spending"); Jeffrey L. Coles et al., ManagerialIncentives & Risk-Taking, 79 J. FIN. ECON. 431, 464 (2006) (finding that "higher sensitivityto stock price volatility in the managerial compensation scheme gives executives theincentive to ... invest in riskier assets" such as more investment in R&D).

113. See Jennifer Francis & Abbie Smith, Agency Costs and Innovation: SomeEmpirical Evidence, 19 J. ACCT. & ECON. 383, 385 (1995) (noting that the difficulty inmeasuring innovation "hinders the design of incentive contracts which are effective atspurring inventive activity").


predictable and easily measured short-term activities. 114As an alternative to compensation devices to promote innovation, a

corporation may de-emphasize short-term or financial measures of success.Management scholars distinguish between strategic and financial internalcontrol systems. The first type of control "emphasize[s] largely subjectiveand sometimes intuitive criteria for evaluation.""' Financial controls, bycontrast, employ objective evaluation criteria such as return oninvestment. 116 While both types of controls facilitate innovation, asignificant emphasis on strategic control is required for sustainedinnovation because strategic controls focus on and evaluate long-termperformance, establish risk-taking norms, and reward activities resulting ininnovation." '7 As explained by Munari and Sobrero, "if managers knowthat they will be evaluated on neither short-term commitments norimmediately measurable achievements, they could have higher incentivesto leverage their tacit knowledge of internal entrepreneurial resources andsupport longer-term development plans."'"18

By contrast, a relatively high emphasis on financial controlundermines innovation because, within the context of quarterly and annualdisclosure requirements mandated by federal securities laws, periodicallyreported financial data are necessarily tied to short-term outcomes. Over-emphasizing financial control may inhibit the communication of tacit andlocal knowledge that is not subject to straightforward measurement andquantification in financial reports. "9 Of course, companies do and mayeven need to improve their internal measures of innovation. 20 However,innovation may be undermined if companies increase their measurement ofinnovation as part of a general shift toward emphasizing short-term

114. See, e.g., Munari & Sobrero, supra note 10, at 11 (observing that financialindicators offer objectivity but are short term in nature, causing managers to move towardslow risk strategies effecting long-term growth and returns); Gustavo Manso, MotivatingInnovation 1 (Jan. 2, 2006) (unpublished research paper, on file with NorthwesternUniversity Kellogg School of Management), available athttp://www.kellogg.northwestern.edulfinance/faculty/seminars/mansoO 11306.pdf (notingthat pay-for-performance compensation "encourages the repetition of what has worked inthe past, but not the exploration of new untested approaches").

115. Michael A. Hitt et al., The Market for Corporate Control and Firm Innovation, 39ACAD. MGMT. J. 1084, 1090 (1996).

116. Id.117. Id. at 1095.118. Munari & Sobrero, supra note 10, at 10.119. Id. at 11; see also Judith L. Estrin, President and CEO, Packet Design LLC,

Remarks at Managing Innovation Wall Street Journal Panel (Sept. 24, 2007), available athttp://video.aol.com/video-detail/risk-and-innovation/369664101 (noting that "all of the[formal processes] that companies have [implemented] for quality and efficiency areessentially enemies of innovation" and that successful innovation requires "being able tomake judgment calls without a lot of data").

120. See generally Andrew et al., supra note 31.

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financial outcomes to the detriment of measuring the full range of inputs,processes, and outputs making up the innovation process.' 2'

C. Objective Versus Proximate Monitoring

Innovation is thus facilitated by decentralization and an emphasis onstrategic internal control. These structures can increase value toshareholders because they reduce an important type .of agency cost faced byinnovative firms. Agency costs are a measure of the loss in value toshareholders (the principals) from directors and managers (the agents)failing to act in the best interests of shareholders. 122

One type of agency cost comes from managers failing to proactivelyuse assets to benefit shareholders. To the extent a company has thepotential to gain from innovation, shareholders are better off whenmanagers undertake actions to adapt to economic change and committhemselves to long-term projects. However, these activities are relativelyrisky for managers to undertake because they require commitment toprojects whose short-term returns are uncertain. Whereas shareholders candiversify their investment portfolios, the risks corporate managers face arenon-diversifiable. Accordingly, managers have a tendency to take on lessrisk and other innovation-related activities than shareholders desire. 23

Managers may focus on short-term gains, more objectively demonstrableperformance, and maintaining current production routines rather than onlong-term innovation projects and strategic renewal. 124 If managers are toomyopic, focusing on short-term financial outcomes when they could beengaging in innovation, shareholders bear an agency cost from foregonebenefits. Firms with a high innovation potential thus bear myopia costsfrom managers who systematically fail to invest in innovation. To reduce

121. See id. 15-17.122. Agency costs are the economic measure of the divergence of interests between

managers and shareholders. Such costs include: those borne by shareholders to monitor,control and give managers appropriate incentives; those bome by managers to convinceshareholders they will act in their best interests (bonding costs); and the loss from anyremaining gap between their interests (the residual loss). Michael C. Jensen & William H.Meckling, Theory of the Firm: Managerial Behavior, Agency Costs and OwnershipStructure, 3 J. FIN. ECON. 305, 308 (1976). For a list of some factors affecting the size ofagency costs, see id. at 328-29.

123. See Munari & Sobrero, supra note 10, at 5 (noting that managers are generally riskaverse and use strategies that increase short-term returns but decrease long-term gains); seealso Jensen & Meckling, supra note 122, at 313 (noting that "as the manager's ownershipclaim falls, his incentive to devote significant effort to creative activities such as searchingout new profitable ventures falls").

124. Munari & Sobrero, supra note 10, at 5-6, 9; Holmstrom, supra note 36, at 324-25(finding that insufficient risk-taking exists in large public corporations because ofmanagement's tendency to choose projects with more easily measurable short-term returns).


myopia and to facilitate innovation, innovative firms may increasedecentralization and adopt more strategic control mechanisms.

While decentralization and strategic control may facilitate innovation,however, these structures may not maximize overall value to shareholders.This is because a firm adopting such structures may increase agency costsfrom managers opportunistically misusing shareholder funds to obtainprivate benefits.125 In general, greater informational asymmetries betweenmanagers and their monitors (e.g., independent directors and investors)increase managerial opportunism. Asymmetries give managers the abilityto benefit themselves because in such situations the costs of monitoring arehigh and it is difficult for outside monitors to evaluate management'sconduct. 126 Innovation activities are difficult to measure or evaluate in theshort-run, in part because they utilize tacit and particularized knowledgeand therefore create information asymmetries between corporate monitorsand managers.' 27 Accordingly, to the extent they increase informationasymmetries, governance structures that facilitate innovation may increasethe ability of managers to behave opportunistically. For example,undertaking R&D allows managers to entrench themselves againstnewcomers, forego dividend payments to shareholders, and invest inprojects that benefit themselves at the expense of the company.'28

125. See Oliver Hart, Corporate Governance: Some Theory and Implications, 105ECON. J. 678, 681 (1995) (discussing how the need for corporate governance arises from thecombination of agency costs and incomplete contracts); Jensen & Meckling, supra note 122,at 312, 325 (arguing that limitations on managerial discretion reflect a tradeoff between"impos[ing] costs on the firm because they limit [a manager's] ability to take full advantageof some profitable opportunities" such as those exploited through entrepreneurship, andbenefiting the firm by "limiting [a manager's] ability to harm the stockholders while makinghimself better off'); see also Lynn A. Stout, The Mythical Benefits of Shareholder Control,93 VA. L. REv. 789, 791 (2007) (noting that delegation of decision-making to a board ofdirectors "while increasing agency costs [from opportunism], also promotes efficient andinformed decisionmaking, discourages intershareholder opportunism, and encouragesvaluable specific investment in corporate team production").

126. See Henry Hansmann & Reinier Kraakman, The Basic Governance Structure, inTHE ANATOMY OF CORPORATE LAW: A COMPARATIVE AND FUNCTIONAL APPROACH 21(Reinier Kraakman et al. eds., 2004) (noting that a core agency problem arises because "theagent commonly has better information than does the principal about the relevant facts,[and] the principal cannot costlessly assure himself that the agent's performance is preciselywhat was promised. As a consequence, the agent has an incentive to act opportunistically... ."). This dynamic is well developed in the corporate governance literature dealing with theoptimal portion of outside directors on a board. See Boone et al., supra note 95, at 70-71(describing various formulations of the "monitoring hypothesis" which includes the viewthat "firms facing greater information asymmetry will have smaller and less independentboards because of the higher costs of monitoring").

127. See David Aboody & Baruch Lev, Information Asymmetry, R&D, and InsiderGains, 55 J. FIN. 2747, 2749-50 (2000) (identifying the idiosyncratic nature R&Dinvestment that gives rise to relatively high information asymmetries).

128. See Kee H. Chung et al., Corporate Governance and Market Valuation of Capital

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To maximize value to shareholders, therefore, a firm must choosebetween reducing agency costs from myopia and reducing those fromopportunism. 2 9 With respect to choosing monitoring devices, this choice

gives rise to the fundamental governance tradeoff between proximate and

objective monitoring. As identified by Arnoud Boot and Jonathan Macey,

Proximity exists when monitors maintain close contact with

management and participate in important decisions on a real-time

basis. Objectivity exists when monitors ... remain distant from

management and evaluate management's performance without

influence by management.

A tradeoff between monitoring functions exists because monitors

that obtain close proximity necessarily forego objectivity, and

objective monitors must maintain sufficient distance from

management, which results in a loss of the advantages ofproximity. 130

As compared to outside monitors, proximate monitors better facilitate

knowledge generation and communication because their close contact withmanagement and real-time participation in decision making means that theyhave more knowledge about the company and are in a better position tocommunicate tacit knowledge efficiently. Likewise, proximate monitorsare in a better position to mitigate the informational asymmetries involvedwith giving substantial discretion to decision-makers to adapt to change.The more in-depth knowledge of proximate monitors also endows them

and R&D Investments, 12 REv. FIN. ECON. 161, 162 (2003) ("It is well known that, absentmonitoring and bonding, corporate executives can and often do make suboptimal investmentdecisions in order to maximize their own utility at the expense of shareholders.Consequently, the level of capital and R&D expenditures per se may not be a properindicator to judge the effect of those expenditures on firm value."); Andrei Shleifer &Robert W. Vishny, Management Entrenchment: The Case of Manager-SpecificInvestments, 25 J. FIN. ECON. 123, 123-32 (1989) (describing managerial incentives to investin projects involving manager-specific knowledge so as to increase the cost of replacing themanager); see also Munari & Sobrero, supra note 10, at 13 ("[T]he decision to carry onR&D activities inherently involves high agency costs, since R&D projects are typicallyrisky, unpredictable, long-term oriented and multistage, labour intensive andidiosyncratic."); Rajesh K. Aggarwal & Andrew A. Samwick, Empire Builders and

Shirkers: Investment, Firm Performance, and Managerial Incentives, 12 J. CORP. FIN. 489,489-515 (reviewing theories of agency costs from empire building); Zahra, supra note 68, at1716 ("High R&D spending may also reflect high agency costs, with managers attemptingto keep funds within a firm rather than distribute them to shareholders.").

129. See Foss & Klein, supra note 51, at 73 (noting that "various constraints firmsimpose on employees. .. to curb destructive entrepreneurship [e.g., opportunism] may havethe unwanted side effect that productive entrepreneurship is stifled"); Holmstrom, supranote 36, at 322-23 (noting that increasing monitoring and influence over managersundermines innovation).

130. Arnoud W.A. Boot & Jonathan R. Macey, Monitoring Corporate Performance:The Role of Objectivity, Proximity, and Adaptability in Corporate Governance, 89 CORNELLL. REv. 356, 357 (2004).


with greater capabilities to employ strategic control mechanisms toevaluate and steer the long-term progress of innovation projects. In thissense, proximate monitoring encompasses the activity of strategicmonitoring, except that proximate monitoring also takes place as projectsare being undertaken, not just after the fact. Proximate monitoring istherefore the type of monitoring most aligned with decentralization andstrategic control in reducing myopia and facilitating innovation. Whileproximate monitoring may be strongest when undertaken by companyinsiders such as executive managers, outsiders (e.g., institutions withconcentrated ownership of shares) may also engage in proximatemonitoring.

Proximate monitoring entails a potential cost, however, becauseproximate monitors may be "captured" by management and thus fail toevaluate managers in the best interests of shareholders.'31 Managementcapture increases informational asymmetries and thereby increasesopportunism costs. To reduce opportunism costs, a corporation mayincrease objective monitoring of managers. Objective monitoringstructures, in contrast to structures facilitating proximate monitoring,include increasing the portion of independent directors on a board andplacing a greater emphasis on internal control over financial reporting."'Subjecting agents to civil and criminal liability may also reduce agencycosts incurred through misappropriation of assets and fraud. Yet becausethere is a tradeoff between proximate and objective monitoring, increasingobjective monitoring likely comes at the expense of increasing myopia andreducing innovation activity.

How a value-maximizing company should strike the balance betweenobjective and proximate monitoring depends in part upon whether it suffersfrom relatively higher agency costs from myopia or from opportunism. Allthings being equal, investors in companies with high innovative potentialwill likely benefit more from proximate monitoring than objectivemonitoring. As corporations become extremely large and diversified intheir operations, however, the potential for opportunism may outweigh thecosts from myopia such that an emphasis on objective monitoring ispreferable even amidst a high level of innovation.' 33 Thus, the proper mixof objective and proximate monitoring that maximizes value toshareholders will differ among public companies.

131. Id. at 359.132. Jensen & Meckling, supra note 122, at 323.133. See Boone et al., supra note 95, at 71 (reviewing corporate governance literature

which finds that "[t]he net benefits of extra [objective] monitoring increase with managers'opportunities to consume private benefits [i.e., act opportunistically], but decrease with thecost of monitoring" such that "optimal boards will employ large numbers of outsidedirectors, and be larger in overall size, when managers' private benefits are high and thecost of monitoring is low").

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III. THE IMPACT OF SOX AND RELATED REFORMS

SOX and related corporate governance reforms are the most wide-ranging and extensive rules to apply to public companies since passage ofthe Securities Act of 1933 and the Securities Exchange Act of 1934.134

Evidence thus far demonstrates that SOX likely had a disproportionate andnegative impact on the shareholders of smaller public companies.'35 ThisPart suggests that the cumulative impact of SOX may also have adisproportionate and negative impact on the stakeholders of innovativepublic companies. While any one of the effects of SOX described belowmay not be significant when taken in isolation, when combined, their neteffect likely undermines the innovative potential of a significant portion ofU.S. publicly listed companies.

SOX's three primary changes to the U.S. federal corporate governanceregime were to increase objective monitoring of managers by outsiders, toincrease the emphasis on financial control, and to heighten civil andcriminal penalties for violations of the federal securities laws. Thelegislation requires each director on the board's audit committee to beindependent. 3 6 The New York Stock Exchange ("NYSE") and NASDAQlisting standards, passed in response to SOX and a request by the Securitiesand Exchange Commission (SEC),' 37 also require a majority of a

134. The Securities Act and the Securities Exchange Act are codified at 15 U.S.C.§§ 77a-77aa (2000) and at 15 U.S.C. §§ 78a-78nn (2000), respectively.

135. See, e.g., Ehud Kamar et al., Sarbanes-Oxley's Effects on Small Firms: What is theEvidence? 27 (Harvard Law School, John M. Olin Center for Law, Economics andBusiness, Working Paper No. 588, 2007) ("[Tlhe evidence offers qualified support for theview that SOX had a negative effect on the value of small firms, at least initially.").

136. The Sarbanes-Oxley Act of 2002 § 301, 15 U.S.C. § 78j-l(m)(3)(A) (2002). Aninside/non-independent director is typically a member of the corporation's seniormanagement, and may own company stock and stock options as incentive compensation.By contrast, under SOX and the exchanges' listing standards, an independent director is nota member of management (or otherwise employed by the corporation) and, other thanreceiving a fee for serving as a director, has no financial ties to the corporation (e.g., as aconsultant or through greater than 10 percent stock ownership, or familial ties toexecutives). See Donald C. Clarke, Three Concepts of the Independent Director, 32 DEL. J.CoRPt. L. 73, 84-94 (2007) (discussing the general characteristics of a director on the board).An outside director is not a corporate employee, but may otherwise be tied to thecorporation through financial or personal ties. Id. at 99 (stating that an outside director is"any director who is not a company employee, without regard to whether she meets astandard of independence") (internal citation omitted). Independent and outside directorstypically do not work for the company full-time.

137. SEC Press Release, Pitt Seeks Review of Corporate Governance, Conduct Codes,Feb. 13, 2002, available at http://www.sec.gov/news/press/2002-23.txt ("As part of anongoing effort to bolster investor confidence, Chairman Harvey L. Pitt of the Securities andExchange Commission has asked the New York Stock Exchange and Nasdaq to review


company's board to be independent (the NYSE in particular requireswholly independent nominating/governance and compensationcommittees). 38 Under SOX, the audit committee must also include afinancial expert.'39 SOX also seeks to improve monitoring of managementby prohibiting external auditors from providing any non-audit services toissuers, requiring auditors to rotate every five years, and requiring attorneysto report any violations of securities laws or breach of fiduciary duty up thecorporate hierarchy to in-house attorneys, the CEO, and ultimately theaudit committee. '40

SOX Section 404 ("Section 404") requires management to maintain,evaluate, and report on internal control over financial reporting.14' Internalcontrols are meant to provide reasonable assurance that financial reportingand preparation of financial statements are reliable for investors and inaccordance with generally accepted accounting principles ("GAAP"). 142

Management must produce an annual report about the company's internalcontrol that evaluates its effectiveness and discloses any materialweaknesses. 143 Under Section 404, a material weakness in internal controlmust be reported when there is "a reasonable possibility" that a materialfinancial misstatement "will not be prevented or detected on a timely

corporate governance and listing standards, including the important issues of officer anddirector qualifications ....").

138. NYSE, Inc., Listed Company Manual § 303A(1)-A(2) (2002) (requiring majorityboard independence); NYSE, Inc., Listed Company Manual § 303A(4)-(6), A(7)(c)(requiring independent audit, nominating/corporate governance and compensationcommittees); NASDAQ, Inc., Manual § 4350(c)(1) (2006).

139. The Sarbanes-Oxley Act of 2002 § 407, 15 U.S.C. § 7265 (2002).140. The Sarbanes-Oxley Act of 2002 § 201(a), 15 U.S.C. § 78j-l(a) (2002) (prohibiting

the provision of non-audit services by an auditor); The Sarbanes-Oxley Act of 2002 § 203,15 U.S.C. § 78j-1(j) (2002) (prohibiting a registered public accounting firm from providingaudit services if the lead auditor partner provided audit services in each of the five previousyears); The Sarbanes-Oxley Act of 2002 § 307, 15 U.S.C. § 7245 (2002) (requiringcorporate attorneys to report evidence of a violation of securities laws or breach of fiduciaryduty to the head in-house counsel or CEO and, if the response is inappropriate, to report tothe audit committee, to another committee comprised solely of independent directors, or tothe board as a whole).

141. 13 U.S.C. § 7262 (2002).142. 17 C.F.R. § 240.13a-15(f) (2007); 17 C.F.R. § 240.15d-15(f) (2007). "Reasonable

assurance" does not require perfection in financial reporting: internal control procedures arenot expected to "prevent or detect all misstatements, whether unintentional errors or fraud."71 Fed. Reg. 77,636, 77,639 (December 27, 2006).

143. The Sarbanes-Oxley Act of 2002 § 404, 15 U.S.C. § 7262; 17 C.F.R.§ 229.308(a)(1)-(3) (2007). Section 404 and the SEC's corresponding regulations makemanagement responsible for providing GAAP-compliant control assessments. Scott A.Taub, Deputy Chief Accountant, U.S. Sec. Exch. Comm'n, Address at SEC and FinancialReporting Conference, The SEC's Internal Control Report Rules and Thoughts on theSarbanes-Oxley Act (May 29, 2003) ("What is new in these [SOX implementing] rules, asfar as management's responsibilities, is the requirement to evaluate the effectiveness ofthose controls and provide a report on that evaluation.").

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984 U. PA. JOURNAL OF BUSINESS AND EMPLOYMENT LAW [Voi. 10:4

basis." 144 Reporting a material weakness in control does not mean that a

financial misstatement was made or is likely to be made, but it may be anindication of lower quality financial reporting. 1

45

On a quarterly basis, management must also disclose any material

changes to the internal control system. 46 Section 302 of SOX requires that

the CEO and chief financial officer (CFO) annually certify the truth of the

company's financial and non-financial disclosures, affirm their

responsibility for maintaining internal control, publicly disclose any

significant changes in internal controls, and internally disclose to auditors

and the audit committee any weaknesses in the control system. 47 A public

company's annual report must also include a statement that an outside

auditor reviewed (attested to) management's internal control assessment, 48

and provide the auditor's attestation report. 49 SOX also established the

Public Company Accounting Oversight Board, a quasi-public entity

charged with promulgating new auditing standards and monitoring and

disciplining external auditors. 50 Finally, SOX increased penalties for

violations of the federal securities laws, including increased criminal

liability for false certifications and other types of fraud,'' and allows the

144. 17 C.F.R. 210.1-02 (2007).145. See Kam C. Chan et al., Earnings Management of Firms Reporting Material

Internal Control Weaknesses Under Section 404 of the Sarbanes-Oxley Act, AUDITING: J.PRACTICE THEORY (forthcoming) (finding some evidence of more earnings managementamong firms that report internal control weaknesses), available athttp://ssrn.com/abstract=1078522; Jeffery Doyle et al., Accruals Quality and InternalControl over Financial Reporting, 82 ACCT. REv. 1141 (2007).

146. 17 C.F.R. § 240.13a-15(d) (2007); 17 C.F.R. § 240.15d-15(d) (2007); 17 C.F.R.§ 229.308(c) (2007).

147. 15 U.S.C. § 7241(a) (2002); see also Foreign Corrupt Practices Act of 1977, 15U.S.C. §§ 78dd-1-78dd-3 (2002) (first U.S. statutory provision requiring companies tomaintain internal control).

148. 17 C.F.R. § 229.308(a)(4) (2007).149. 17 C.F.R. § 229.308(b) (2007). Registered public accounting firms auditing a

public company's financial statements are required to "attest to, and report upon"management's assessment of internal control. 17 C.F.R. § 210.2-02(f) (2005). An auditor'sattestation must be made in accordance with standards issued or adopted by the PublicCompany Accounting Oversight Board. Management's Report on Internal Control OverFinancial Reporting and Certification of Disclosure in Exchange Act Periodic Reports, 68Fed. Reg. 36,636, 36,637 (June 18, 2003) (to be codified at 17 C.F.R. parts 210, 228, 229,240, 240, 270 and 274).

150. The Sarbanes-Oxley Act of 2002 § 101, 15 U.S.C. § 7211 (2002).151. The Sarbanes-Oxley Act of 2002 § 807(a), 18 U.S.C. § 1348 (2002) (requiring

increased penalties for defrauding shareholders or publicly held companies); The Sarbanes-Oxley Act of 2002 § 903, 18 U.S.C. § 1341 (2002) (requiring increased penalties for mailand wire fraud); The Sarbanes-Oxley Act of 2002 § 906(a), 18 U.S.C. § 1350(c) (2002)(requiring criminal liability for false certifications); The Sarbanes-Oxley Act of 2002 §1106, 15 U.S.C. § 78ff (2002) (requiring increased penalties for violations of the SecuritiesExchange Act).


SEC to bar those it deems "unfit" to serve as directors and officers. 152

A. SOX and Agency Costs

By increasing outside monitoring and the emphasis on financialcontrol, SOX aims to reduce agency costs from opportunism relating tomanagement's involvement with financial reporting.'53 In response toSOX, some firms may have improved the quality of their financialstatements. 54 In addition, SOX compliance may be able to facilitate someaspects of innovation. SOX had the effect of requiring many companies tochange their information technology capabilities, which may have theconsequence of increasing the communication of innovation-relevantknowledge within a company.'55 Nonetheless, because SOX mandates thatall public companies increase outside monitoring and financial control, andthe law's other related consequences, SOX likely has the more widespreadand significant effect of reducing some companies' ability to engage inproximate monitoring to facilitate innovation.

This effect is important because, in addition to the generalconsiderations regarding management's tendency to not take on as muchrisk as is optimal for investors, there is reason to believe that the costs ofmyopia are significant. In a study based upon a broad cross-section ofpublic corporations, Aggarwal and Samwick found that increasingmanagerial incentives through equity ownership did not increasemanagerial opportunism, but rather increased investments and improvedperformance for all levels of stock-based compensation. 56 They use thisfinding to support the proposition that the principal source of agency costsin public companies is managers failing to expend enough effort to, for

152. The Sarbanes-Oxley Act of 2002 § 305(a)(1)-(2), 15 U.S.C. § 78u (2002).153. See Larry E. Ribstein, Sarbox: The Road to Nirvana, 2004 MICH. ST. L. REV. 279,

282-83 (2004) (noting that SOX "tries to ensure that agency costs and corporate fraud donot again run rampant by requiring more watchers and stiffer penalties").

154. See generally Doyle et al., supra note 145; Kam C. Chan et al., EarningsManagement of Firms Reporting Material Internal Control Weaknesses Under Section 404of the Sarbanes-Oxley Act, AUDITING: A JOURNAL OF PRACTICE & THEORY, available athttp://papers.ssrn.com/sol3/papers.cfm?abstract-id= 1078522; Jian Zhou, FinancialReporting After the Sarbanes-Oxley Act: Conservative or Less Earnings Management?, 20RES. ACCT. REGULATIONS (2007).

155. See Computer Associates, A Key Ingredient for Compliance: Automation 2 (Jan.2006) (arguing that SOX "presents an opportunity to re-engineer and improve existingfinancial business processes, enhancing information sharing and integrity"); PhilippKoellinger, Why IT Matters-An Empirical Study of E-business Usage, Innovation, andFirm Performance, DIW Berlin Discussion Papers 495 (2005), available athttp://www.diw.de/documents/publikationen/73/43300/dp495.pdf (arguing that successfullyimplementing information technology increases innovation).

156. See Aggarwal & Samwick, supra note 128, at 491 (reviewing theories of agencycosts from empire building).

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example, start new product lines.'57 Aggarwal and Samwick's findingstrongly suggests that increasing objective monitoring to reduce managerialopportunism is unlikely to make shareholders in a significant portion ofpublic companies better off. Accordingly, to the extent myopia is the resultof failing to expend additional effort towards long-term activities, reducingmyopia is a more important governance objective than reducingopportunism.

Prior to SOX, companies whose investors would benefit fromrelatively higher outside monitoring and more emphasis on financialcontrol likely had already adopted such structures. 15 8 Yet SOX requires allcompanies to increase objective monitoring (i.e., more independentdirectors and increased emphasis on internal control over financialreporting), including companies for whom the optimal governance structureinvolves relatively more proximate monitoring (i.e., decentralization andstrategic control). Because companies generally adopt the structures thatmaximize value to shareholders, it is unlikely that SOX's mandatorygovernance structures, which attempt to reduce opportunism, would makeinvestors in such companies better off. "9 To the contrary, the evidencedescribed in this Article suggests that the cumulative impact of SOX is totip the scales in innovative firms toward too much-and hence value-reducing--objective monitoring.

The remainder of this Article uses the framework developed in Parts Iand II to analyze the impact of SOX (and the related exchange regulations)on innovation. In discussing the empirical literature, common measures ofinnovation, such as patent activity and R&D spending, are utilized asproxies. 60 However, such indicators are imperfect measures of innovation.Not all innovations are patentable and only a small proportion of patentsultimately lead to successfully commercialized products.' 6 ' Furthermore,R&D spending is merely an input into the innovation process. As such, itdoes not guarantee innovation will occur and is not required for all

157. See id. at 490, 514 (concluding that their research finds no support for the generaltheory that managers act opportunistically, (the "private benefits model"), but findingsupport "for the idea that managers underinvest").

158. See Aggarwal & Williamson, supra note 94, at 23-24 (finding that prior to SOXshare prices were already higher for firms voluntarily adopting governance structuressimilar to those mandated by SOX). This implies that prior to SOX, diversified investorswere generally bearing the optimal amount of agency costs from opportunism. See HENRYN. BUTLER & LARRY E. RIBSTEIN, THE SARBANES-OXLEY DEBACLE: WHAT WE'VE

LEARNED; HOW TO Fix IT 23 (2006) (explaining that there is an optimal amount of fraudrelative to maximizing shareholder value).

159. See Chidambaran et al., supra note 2, at 32-33 (finding that firms adopting "good"governance structures did not improve their performance).

160. Keith Smith, Measuring Innovation, in THE OXFORD HANDBOOK OF INNOVATION,supra note 8, at 152.

161. Jaruzelski et al., supra note 10, at 52-53.


innovations. 162 As previously noted, R&D spending may even reflectmanagerial entrenchment and other types of value-destroying activity. 163

Nevertheless, the impact of SOX on patent activity and R&D spending isimportant because such activities are reflective of the long-term riskyundertakings characteristic of corporate innovation. Empirical researchthat uses these variables likely illustrates the more general impact of SOXon innovation.

B. Assessment and Certification of Internal Control

Management's new SOX-mandated duties to assess and report oninternal control over financial reporting likely decrease their propensity toengage in innovation or related activities. Three interrelated groundsprovide support for this conclusion.

1. Increased Emphasis on Financial Controls

SOX's increased disclosure requirements relating to internal controltend to undermine a long-term, innovation orientation. The very purpose ofSection 404 is to improve the accuracy of numerical financial statementsunder GAAP.64 Furthermore, in part due to SOX's requirement that auditcommittees be composed of one financial expert, the proportion ofdirectors qualified as financial experts (e.g., CFOs, accountants) went fromten percent in 1998 to twenty-one percent by 2004.165 Management's dutyto evaluate and report on the effectiveness of internal controls underSection 404, and the presence of more financial experts on boards, is likelyto increase companies' emphasis on financial versus strategic control.Under SOX, short-term financial reporting takes on a new level ofsignificance. 1

66

162. Peggy M. Lee, A Comparison of Ownership Structure and Innovations of US andJapanese Firms, 26 MANAGERIAL & DECISION ECON. 39, 40 (2005) ("Not all R&D isproductive, and increased R&D does not necessarily translate to increased innovations.")(citations omitted).

163. See supra note 128 and accompanying text.164. Management's Report on Internal Control Over Financial Reporting, 71 Fed. Reg.

77,635, 77,641 (Dec. 27, 2006) (to be codified at 17 C.F.R. parts 210, 240 and 241)("Management should assess whether its controls are designed to provide reasonableassurance regarding the reliability of financial reporting and the preparation of financialstatements for external purposes in accordance with generally accepted accountingprinciples .... ).

165. James S. Linck et al., The Effects and Unintended Consequences of the Sarbanes-Oxley Act on the Supply and Demand for Directors 30-31 (Feb. 4, 2008) (unpublishedresearch paper, on file with University of Georgia Terry School of Business), available athttp://papers.ssm.com/sol3/papers.cfm?abstractid=902665.

166. See Peter J. Wallison, Arthur F. Bums Fellow in Fin. Market Studies, Am. Enter.

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In addition, innovation involves the use of intangible knowledgeassets, including activities such as R&D, intellectual property rights, andorganizational advantages. 167 However, financial reporting under GAAPmay not adequately reflect knowledge assets. 168 For example, R&D

spending is expensed under GAAP, but changes in R&D productivity are

not reported in financial statements, so merely being GAAP-compliant

does not keep shareholders informed about changes in the value of R&D

investments. 169 To the extent SOX increases investor attention to GAAP-

compliant financial statements, it thus increases informational asymmetries

between managers and those who monitor them, thereby increasing the

potential for opportunism. To compensate for increased informational

asymmetries due to SOX's emphasis on GAAP, corporations may adopt

structures that reduce innovative activity. For example, while increasing

objective monitoring may undermine a company's ability to innovate, 7 0 an

innovative corporation reliant upon intangibles, and required by SOX to

increase its emphasis on GAAP-compliant financial statements, may

nonetheless increase the independence of its board to offset the increase in

informational asymmetries resulting from SOX. While such a change may

decrease opportunism, it would likely also decrease a company's

innovation activities. In this way, SOX's emphasis on financial reporting

under GAAP has a particularly negative impact on innovation activities

utilizing intangible assets.

Empirical studies generally support the proposition that SOX's

additional emphasis on financial control decreases innovation activities for

all public companies, regardless of size. '' Hitt et al. find a positive

relationship between an emphasis on strategic control and R&D, and a

negative relationship between emphasizing financial controls and R&D.'

Inst. for Pub. Policy Research, Address at American Enterprise Institute Event on AuditedEarnings, Poor Diagnosis, Poor Prescription: The Error at the Heart of the Sarbanes-OxleyAct (Jan. 23, 2003) (noting that SOX's "principal effect was to enshrine the auditedfinancial statement-prepared under [GAAP]-including a balance sheet, income statementand statement of cash flow, as the central financial disclosure of companies whose sharesare traded in the public securities markets").

167. See Olufunmilayo B. Arewa, Measuring and Representing the KnowledgeEconomy: Accounting for Economic Reality Under the Intangibles Paradigm, 54 BUFF. L.REv. 1, 10-11 (2006) (defining intangibles); supra Part I.A.

168. See Arewa, supra note 167, at 45 ("As a result of the intangibles paradigm shift,financial statements have become less informative [to shareholders] from an accounting andeconomic perspective."); Wallison, supra note 166 (noting that "GAAP financial statementsare inherently unable to produce accurate measures of assets and earnings for companiesthat rely on intangible assets").

169. Aboody & Lev, supra note 127, at 2750.170. See infra Part III.C.171. Studies suggesting that SOX already decreased innovation activities are discussed

in the next section.172. Hitt et al., supra note 115, at 1095-96, 1109.


Other empirical studies have found similar results, and none have found thecontrary. 73 In a study of Chinese firms, Xinmin et al. found that whilestrategic control facilitates radical innovation, it undermines incrementalinnovations. 74 This finding is consistent with the proposition thatsubstantial innovations tend to be long-term in nature, whereas smaller,incremental innovations can be completed on a short-term and morereadily-verifiable basis. Overall, the positive correlation between strategiccontrol and R&D suggests that decision making based on in-depthoperational knowledge is in some ways more important for innovation thanquantitative information or data from financial control. Operationalknowledge increases in importance in dynamic environments wheresuccess depends upon bearing risks that are not subject to straightforwardquantification.' 75 SOX's emphasis on financial control thus likelyundermines innovation in firms that, prior to the law, relied more heavilyon strategic control to reduce the costs of myopic decision-making.

2. Financial Reporting Risk and Innovative Risk-Taking

The likely negative impact upon innovation from increasing anemphasis on financial controls is compounded by an underlying tensionbetween management's duty to perform a risk-based assessment of internalcontrol under Section 404 and management's undertaking of riskyinnovation activities. 176 SOX seems to have increased the likelihood ofhaving to disclose an internal control weakness when undertakinginnovation. Accordingly, because disclosure of a material weakness incontrol may increase a company's cost of capital and decrease the price ofits stock even when no financial misstatements occur, 177 SOX may havemade managers more reluctant to engage in innovation activities solely toavoid having to disclose a weakness in internal control.

The SEC's guidance regarding management's assessment of internalcontrol under SOX states that management should employ a "top-down,

173. Munari & Sobrero, supra note 10, at 11.174. Liu Xinmin et al., The Impact of a Firm 's Internal Control Mechanisms on the

Choice of Innovation Mode, I FRONTIERS Bus. RES. CHINA 91, 99-100 (2007).175. See Munari & Sobrero, supra note 10, at 12.176. This tension is reflected in a post-SOX director survey which found a tension

between directors' increased risk-management role under SOX and management's risk-taking role. ERNST & YOUNG, BOARD MEMBERS ON RISK: LEVERAGING FRAMEWORKS FORTHE FUTURE 11 (2006).

177. See Jaqueline S. Hammersley et al., Market Reactions to the Disclosure of InternalControl Weaknesses and to the Characteristics of those Weaknesses under Section 302 ofthe Sarbanes Oxley Act of 2002, 13 REv. ACcT. STUD. 141, 144-45 (2007); HollisAshbaugh-Skaife et al., The Effect of Internal Control Deficiencies on Firm Risk and Costof Equity 4-6 (Feb. 2007) (unpublished research paper), available athttp://ssm.com/abstract=896760.

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risk-based" approach. 78 This means that management must identify therisks of inaccurately reporting financial statements, design internal controlsto adequately prevent or detect financial misstatements, and gather moreevidence and perform more extensive testing in areas deemed to have morefinancial reporting risk.7 9 The SEC identifies several characteristics oftransactions and their controls that increase the risk of financialmisstatement. These characteristics include transactions involving higheragency costs (e.g., where controls are more susceptible to being overriddenby management'), high-risk transactions susceptible to substantialeconomic loss, controls requiring substantial subjective judgment oraccounting complexity to be properly implemented, interdependentcontrols, and transactions subject to economic and technological change.'In addition, a SOX compliance guide notes that a common source ofmaterial weakness in internal controls is "[i]nadequate controls associatedwith the recording of nonroutine, complex, and unusual transactions."'8 2

178. Commission Guidance Regarding Management's Report on Internal Control OverFinancial Reporting Under Section 13(a) or 15(d) of the Securities Exchange Act of 1934,72 Fed. Reg. 35,324, 35,324 (June 27, 2007) (to be codified at 17 C.F.R. part 241)[hereinafter SEC Guidance] (promulgating interpretative guidance which "sets forth anapproach by which management can conduct a top-down, risk-based evaluation of internalcontrol over financial reporting"). Although the SEC's guidance is technically not theexclusive way to evaluate internal control, it is at least broadly indicative of what the SECconsiders to be the types of transaction characteristics contributing to the risk of financialmisstatement, and it is very likely to be relied upon by attorneys, judges, and companies indetermining the contours of legal risk. See Amendments to Rules Regarding Management'sReport on Internal Control Over Financial Reporting, 72 Fed. Reg. 35,310, 35,310 (June 27,2007) (to be codified at 17 C.F.R. parts 210, 228, 229 and 240) (noting that the SEC'sproposed guidance is one of many ways to conduct an evaluation of internal control).Furthermore, the SEC's top-down risk-based approach is not entirely new. At least a decadebefore SOX, the importance of evaluating the risk of financial misstatement was widelyrecognized. See COMMITTEE ON SPONSORING ORGANIZATIONS OF THE TREADWAY

COMMISSION, INTERNAL CONTROL-INTEGRATED FRAMEWORK (2004) [hereinafter COSO];MICHAEL RAMOS, HOW TO COMPLY WITH SARBANES-OXLEY SECTION 404: ASSESSING THE

EFFECTIVENESS OF INTERNAL CONTROL 49 (2d ed. 2006) (recognizing that the 1992 COSOframework identifies new products, new activities, and the integration of new technology asfactors that increase financial reporting risk). COSO is a private-sector body made up ofseveral major executive and accounting related professional organizations that publish

guidance on internal control and other related financial reporting matters. The SECconsiders the COSO control framework to be suitable for management's assessment underSection 404. See SEC Guidance at 3 n. 10 (providing a history on the Sarbanes-Oxley Act in

relation to section 404).179. SEC Guidance, supra note 178, at 35,325, 35,327, 35,331.180. For a summary of the issues involved with so-called "management override," see

AMERICAN INSTITUTE OF CERTIFIED PUBLIC ACCOUNTANTS, MANAGEMENT OVERRIDE OF

INTERNAL CONTROLS: THE ACHILLES' HEEL OF FRAUD PREVENTION (2005).181. SEC Guidance, supra note 178, at 35,330, 35,335.

182. STEPHEN M. BAINBRIDGE, THE COMPLETE GUIDE TO SARBANES-OXLEY:UNDERSTANDING How SARBANES-OXLEY AFFECTS YOUR BUSINESS 219 (2007).


Guidance by a leading audit firm also finds that firms must avoidcapitalizing intangible assets before a new product is technologicallyfeasible. "3

Under SOX's specific top-down, risk-based approach, management'sassessment of internal control under SOX must place a special emphasis oninnovation activities. Because innovation requires management to havesubstantial discretion to focus on long-term activities not easily measuredin the short term, it necessarily involves transactions where managers canpotentially manipulate financial data and act opportunistically at theexpense of shareholders. Innovation and entrepreneurship also tend to behigher risk activities that rely upon manager's subjective judgmentregarding the potential value of hard-to-quantify assets and opportunities.Accordingly, subjective judgment may be required to properly implementcontrols for such transactions. Furthermore, because many of the activitiesinvolved in innovation are interdependent and organization-wide, changingcontrols over one activity may impact controls over another activity.Innovation activities may also involve non-routine and unusualtransactions. Finally, properly accounting for innovation activitiesinherently creates the risk of capitalizing on the value of intangible assets(i.e., ideas) before a new product is commercially feasible.

Innovation and related activities thus possess the same characteristicsidentified by the SEC and others as contributing to the risk of financialmisstatements. Studies of post-SOX disclosures of internal controlweaknesses found more frequent disclosures of control weaknesses incompanies operating in either dynamic business environments orundergoing rapid growth and internal change. 8 4 Because innovationactivities are more likely to be found in companies subject to change orundergoing organizational change," 5 these studies provide indirectempirical support that innovation activities tend to be a source of higherreporting risk than more routine, non-innovation activities. In addition, asurvey by Financial Executives International found that public companieswith a decentralized operational structure experienced over twice theinternal control compliance costs (four million dollars) as those with

183. ERNST & YOUNG, EMERGING TRENDS IN INTERNAL CONTROLS: FOURTH SURVEY ANDINDUSTRY INSIGHTS 126 (2005).

184. Hollis Ashbaugh-Skaife et al., The Discovery and Reporting of Internal ControlDeficiencies Prior to SOX-Mandated Audits, 44 J. ACCT. & ECON. 166, 190 (2007) (findingrelatively more internal control weaknesses among firms that are faster growing, have moreoperating segments and foreign transactions, and engaging in mergers and acquisitions andrestructurings); Jeffrey Doyle et al., Determinants of Weaknesses in Internal Control OverFinancial Reporting, 44 J. ACCT. & ECON. 193, 220 (2007) (finding more disclosures ofmaterial weaknesses in internal control from firms with more operating segments, engagingin foreign currency translation, and that are smaller and younger).

185. See supra Parts I.B and I.D.

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centralized operations. 8 6 Because innovative companies tend to haverelatively decentralized operations, this study supports the relatedproposition that SOX places a relatively higher internal control burden onsuch firms. Finally, a case-study of small and medium sized companiesrequired to comply with SOX revealed that delays in internal controlassessments became more pronounced as transaction complexityincreased.187 This finding is consistent with the proposition that, becauseinnovation-related transactions tend to be more complex from a control oraccounting perspective, innovation transactions and controls are a morecostly aspect of the SOX-mandated internal control assessment process.

Because innovation activities are a relatively higher source offinancial reporting risk, they are also likely a more costly component ofmanagement implementing and maintaining a control system that providesreasonable assurance of financial statement accuracy under Section 404.Innovation-related controls may generally require more extensivedocumentation and testing under a top-down, risk-based approach. Allthings being equal, management is less likely to engage in innovation post-SOX because doing so increases the risk of having to report a materialweakness in internal control even where financial statements are notactually compromised. 188 A guide that advises how to comply with SOX'sinternal control requirements suggests that one straightforward way toreduce financial reporting risk is to "choos[e] to not undertake the activitythat gives rise to the risk."' 89 The post-SOX empirical record thus far isconsistent with such advice.

A study by Bargeron et al. compared the differences between 2,290public corporations in the U.S. and U.K. (which do not have to complywith SOX) before and after SOX regulation became effective (from 1994through 2006).'90 Post-SOX, the authors found that R&D spending forU.S. companies decreased while R&D spending increased for U.K.firms.' 9' The authors also found that, in contrast to U.K. firms, after SOX,U.S. firms in R&D intense industries were less likely to go public and may

186. FINANCIAL EXECUTIVES INTERNATIONAL, FEI SURVEY ON SARBANES-OXLEY

SECTION 404 IMPLEMENTATION 8, 17 (2007).187. Vicky Arnold et al., The Unintended Consequences of Sarbanes-Oxley on

Technology Innovation and Supply Chain Integration, 4 J. EMERGING TECHNOLOGIES ACCT.103, 117 (2007).

188. Another effect of this result may be to increase the cost of raising and borrowingcapital for innovative public companies. See Butler & Ribstein, supra note 158, at 47(arguing that SOX may reduce the flow of resources to firms engaging in "novel businesspractices" because such firms are "subject to increased liability risk under SOX").

189. RAMOS, supra note 178, at 48 (emphasis in original).190. Leonce Bargeron et al., Sarbanes-Oxley and Corporate Risk-Taking (Mar. 6, 2008)

(unpublished research paper, Katz Graduate School of Business, University of Pittsburgh),available at http://ssm.com/abstract = 104063.

191. Id. at 15.


have decreased their risk-taking overall. 92 Similarly, Cohen et al. found asignificant post-SOX decline in R&D spending. 93 In addition, a study byKang and Liu analyzed the impact of SOX on managerial risk-taking byusing a "hurdle rate," which is the minimum rate of return a managerwould require before deciding to invest in a project. '94 The authors found asignificant increase in the hurdle rate after the implementation of SOX andattributed the increase to managers becoming more cautious in theirinvestment decisions.195 This finding can also be explained bymanagement's attempt to avoid risky innovation activities that create arelatively greater risk of having to disclose an internal control weakness.

3. Organizational Flexibility

Compliance with SOX's internal control duties may reduceorganizational flexibility within corporations and thereby undermineinnovation through strategic renewal or other attempts to adapt tochange. 196 Findings from the SEC's own Advisory Committee on SmallerPublic Companies (Advisory Committee) support this conclusion. TheAdvisory Committee found that SOX undermined flexibility in smallcompanies based on two observations. First, smaller companies aredynamic and constantly evolving, requiring frequent changes in productionprocesses and job duties within the company. '9' This dynamism limits theability of small companies to have well-documented production processesas required by SOX because "[f]lexibility and quick change often meansthat processes and [internal] controls change, and consequently that thedocumentation of those controls change" quickly as well.' 98 Second, insmaller companies decision makers "wear multiple hats."' 99 Duties are notclearly segregated between undertaking business projects and financialreporting. As a result, top managers responsible for operations are also

192. Id. at 21-23.193. Daniel A. Cohen et al., The Sarbanes-Oxley Act of 2002: Implications for

Compensation Contracts and Managerial Risk-Taking 19, 22 (Nov. 2007) (unpublishedresearch paper, on file with New York University Stem School of Business), available athttp://ssrn.com/abstract=-568483.

194. Qiang Kang & Qiao Liu, The Sarbanes-Oxley Act and Managerial Risk Taking: AStructural Assessment 4 (March 1, 2007) (unpublished research paper, on file with theUniversity of Miami), available at http://papers.ssm.cornsol3/papers.cfn?abstractid=967950.

195. Id. at 15.196. SOX's independent director requirements may also undermine flexibility. See infra

Part III.C.197. ADVISORY COMM. ON SMALLER PUBLIC COMPANIES, U.S. SEC. & EXCH. COMM'N,

FINAL REPORT 36 (2006).198. Id. at 38.199. Id. at 35.

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involved in financial reporting.200 This combination of constantly changingcontrol processes and management's involvement in documenting thosechanges, means that SOX's additional financial reporting duties divertoperational assets to documenting and reporting changes in internalprocesses, thereby increasing the cost of such changes. Accordingly, theAdvisory Committee concluded that SOX compliance causes dynamiccompanies that utilize top management in the financial reporting process tolose flexibility.2 '

While the Advisory Committee limited its findings to small publiccompanies, it is also the case that large, innovative companies are dynamicand therefore have management overlap in their operational and financialreporting functions. First, large innovative companies dynamically adapt toeconomic change by engaging in strategic renewal, changing their routinesto integrate new products and adopting radical process innovations. The

organizational changes arising from such activities implicate processes inseveral different parts of a company and may result in a large corporationchanging previously established boundaries, controls, and productionprocesses.202

Second, even though large corporations segregate operational andinternal control functions, there is still significant overlap between topmanagement's operational duties and those duties related to financial

reporting. As the response by Apple described in the introduction to thisArticle illustrates, innovation may require operational managers to interactwith those involved in financial reporting and accounting to properly

exercise judgment about how an innovation should be undertaken. Whenorganizational innovation or a substantial change in routines takes place,under Section 404 management must assess the impact of such changes oninternal control and reporting risk.203 In addition, SOX requiresmanagement to disclose on a quarterly basis any material changes tointernal control,2 4 which may include those that result from a large

company undergoing substantial organizational change or strategicrenewal. Furthermore, although SOX only mandates that the CEO andCFO certify the reliability of the internal controls, this requirement has theunintended consequence of requiring, on average, 22 additional executives

200. Id.201. Id. at 36.202. See Stieglitz & Heine, supra note 81, at 6 (noting that successfully implementing

substantial and radical innovations may require cutting across the traditional organizationalboundaries within the firm).

203. See RAMOS, supra note 178, at 49-50 (identifying new activities and restructuringsas conditions likely to increase financial reporting risk under Section 404).

204. 17 C.F.R. § 240.13a-15(d) (2007); 17 C.F.R. § 240.15d-15(d) (2007); 17 C.F.R.§ 229.308(c) (2007).


to sign internal control sub-certifications.0 5 A 2003 survey found that amajority of all financial professionals provide information ultimately usedin their companies' publicly disclosed financial reports and that a thirdwere required to sign section 302 sub-certifications.2 6 Although most ofthese financial professionals were already involved in financial reporting(e.g., treasurers), a significant portion of those found to be newly requiredto sign the sub-certifications were made up of operational directors,managers, and company vice presidents.2 7 It is also highly likely thatsubordinates to operational managers who are newly required to sign sub-certifications have a role in supporting the sub-certifying manager in thefinancial reporting process.

The dynamic nature of large innovative companies and management'sinvolvement in financial reporting thus indicate that SOX reducesflexibility in large companies as it does in small public companies, throughperhaps to a lesser extent. Accordingly, SOX likely increases the cost ofstrategic renewal, new product integration, and radical innovation byincreasing the involvement of managers and other employees, who areotherwise tasked with running the company, in the financial reportingaspects of the business. Consistent with the foregoing is a case study ofboth small and medium-sized public companies finding that SOXcompliance substantially reduced organizational flexibility due to concernsover having to report a material weakness in internal control.2 8

Furthermore, the studies finding internal control weaknesses more likely incompanies undergoing rapid change 20 9 are consistent with the propositionthat SOX increases the cost of such change and, accordingly, mayundermine the organizational and operational flexibility that facilitatesinnovation.

In sum, Section 404 increases the emphasis on financial versusstrategic control, increases the cost of internal control assessments andreporting risks associated with innovation activities, and hampers theflexibility of even large public companies. The combined impact of theseeffects likely reduces the innovation capability of public companies that,but for SOX, would place a relatively greater emphasis on strategic control,undertake more activities facilitating innovation, and adapt to changethrough organizational innovation.

205. See Jo Lynne Koehn & Stephen C. DelVecchio, Revisiting the Ripple Effects of theSarbanes-Oxley Act, CPA J. ONLINE, May 2006, http://www.nysscpa.org/printversions/cpaj/2006/506/p32.htm (reporting survey results showing that "22.5 executives, other than theCEO and CFO, will be required to submit subcertifications").

206. Assoc. FOR FIN. PROFESSIONALS, SUBCERTIFICATION: FINANCIAL PROFESSIONALSTAKING THE LEAD ON SARBANES-OXLEY 2 (2003).

207. Id. at 2-4.208. Arnold et al., supra note 187, at 21-25.209. See supra note 184 and accompanying text.

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C. More Independent and Larger Boards

Prior to SOX, there was a trend towards smaller board size and greaterindependence among public companies, due in part to shareholder activism

and public pressure. 210 Although SOX reversed the trend towards smaller

boards, it increased the trend towards greater board independence.Before SOX was passed, about two-thirds of the directors on public

company boards were comprised of outside or independent directors, 21' andseventy-five percent of all companies traded on the NYSE had a majorityof independent directors. 2 In 2000, 38.5 percent of 500 of the largestU.S.-listed public companies (i.e., those on the S&P 500 index) did nothave fully independent audit committees as would later be mandated bySOX. 21 3 In 2001, 10.2 percent of all public companies did not have a

majority of independent directors on their boards, 4 and neither did about

eleven percent of the S&P 500 in 2000, as would later be required by thepost-SOX NYSE and NASDAQ listing standards.21 5 Furthermore, high-

tech innovative companies were generally even less SOX compliant before

the law was passed. In 2000, "new economy" companies had a lower ratio

of independent directors and a slightly higher likelihood of having an

insider-dominated board than their "old economy" counterparts.21 6

Subsequent to SOX, both the percentage of independent directors and

the percentage of public company boards with a majority of independent

directors increased. Linck et al. found that from 2001 to 2004, the

percentage of outside directors on boards increased from 66.3 to 70.8

percent, and that the percentage of boards with a majority of inside

directors decreased from 10.2 to 4.6 percent.21 7 Although these changes

210. Linck et al., supra note 165, at 23.211. Id. at 23 (finding that 66.3 percent of directors were outsiders in 2001); Vidhi

Chhaochharia & Yaniv Grinstein, The Transformation of U.S. Corporate Boards: 1997-2003 36, tbl.1 panel A (May 2004) (unpublished research paper, on file with Cornell

University) (finding 64.04 percent of directors independent in 2000), available athttp://ssrn.com/abstract-556270.

212. Clarke, supra note 136, at 73 n.2.213. Chhaochharia & Grinstein, supra note 211, at 39 tbl.1, panel E by size (showing

that in 2000 61.49 percent of S&P 500 companies had independent audit committees).214. Linck et al., supra note 165, at 40, Fig. 1 panel B. Annual figures on file with

author.215. Id. at 36, tbl.1, panel A (finding that in 2000 81.88 percent of public companies had

a majority of independent directors); id. at 36, tbl.1, panel B (finding that in 2000 89.79percent of S&P 500 companies had a majority of independent directors). Another measure

of large public companies comes to similar results, finding that in 2000 insider-dominatedboards comprised 9 percent of companies having a median market capitalization of $2.07billion. Linck et al., supra note 94, at 316-17.

216. Chhaochharia & Grinstein, supra note 211, at 37 tbl.1 panel C.217. Linck et al., supra note 165, at 40 Fig. 1 panels A-B (annual data on file with

author); see also Chhaochharia & Grinstein, supra note 211, at 37, tbl. 1, panel C (finding


were continuations of trends already in place prior to SOX, they alsobecame more pronounced after SOX and likely reflect specific efforts tocomply with the law. 218 To become SOX compliant, companies tended toadd independent directors rather than replace insiders, which is reflected inpublic company board size increasing on average by 8.4 percent from 2001to 2004 (which reversed the prior 12-year trend in decreasing boardsize). 219 In absolute terms, the increase in board size post-SOX was notsubstantial. Disaggregated by firm size, from 2001 to 2004 the averagenumber of directors for large, medium, and small public companiesincreased from 9.3 to 10.3, 7.3 to 7.8, and 6.1 to 6.5, respectively. 220

SOX and related independent director requirements thereforeincreased outside monitoring across all sizes of public companies, and wasat least in part responsible for about ten percent making a fundamentalswitch from having a board with a majority of insiders to one with amajority of outsiders. Losing a majority of inside directors, or adding justone or two more independent directors, may significantly alter a company'sdecision making with respect to innovation. As suggested by empiricalcorporate governance research discussed below, innovation decisions aresensitive to board composition and board size. Independent and insidedirectors make different contributions to innovation, and the size of a boardhas an impact on the nature of its decision making.

Independent directors can facilitate innovation by aligning incentivesof managers and shareholders, expanding the base of expertise from whichmanagement can draw, enhancing objectivity in director decision making,and encouraging managers to pursue corporate entrepreneurship.22'However, because independent directors are not involved in day-to-dayoperations and likely have little or no stock ownership interest in thecorporation, their capabilities and incentives to promote corporateentrepreneurship are limited.222 By contrast, inside directors "are likely tobe better informed about the sources of uncertainty and the potential returnsstemming from innovative projects, and therefore they are more qualifiedto promote and assess such undertakings.' ' 23 Inside directors are in a betterposition to assess the merits of entrepreneurial projects because they areinvolved in the strategy process and have working knowledge of the

that new economy companies increased their independent board representation from 2000 to2003 from 62.13 percent to 67.01 percent, a 7.8 percent increase).

218. Linck et al., supra note 165, at 27-29.219. Id. at24.220. Linck et al., supra note 94, at 318 Fig. 1 panel C. Annual data on file with author.221. Zahra, supra note 68, at 1717.222. Id.223. Munari & Sobrero, supra note 10, at 20; see also Zahra, supra note 68, at 1718

(noting that corporate entrepreneurship requires making informed judgments in the face ofuncertainty).

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corporation.2 4 Inside directors also have greater abilities and moreincentives to increase communication and new product integration becausethey are involved in the day-to-day decision making of the company.225

Inside directors, because they generally possess greater knowledge ofcorporate operations and industry changes than outsiders, are likely in abetter position to facilitate strategic renewal.226 Organizational flexibility isalso generally facilitated when managers have substantial discretion topursue projects without being micromanaged or second-guessed by thirdparties, 22' a phenomenon that may increase the more independent andlarger the board.

Accordingly, a board of directors which best facilitates innovation iscomprised of some optimal balance of independent and inside directors.The relevant empirical evidence suggests that SOX, by increasing directorindependence, upset the optimal balance in certain innovative public

221companies.In a study of 1,526 publicly traded companies around the passage of

SOX, Wintoki examined returns around important SOX-related events andfound that the returns for companies with relatively higher monitoringcosts, as determined by factors including R&D spending and growthopportunities, were abnormally low. 229 This finding was attributed to such

firms benefiting from having a significantly smaller proportion of

independent directors and SOX's director mandates undermining the

performance of such companies. 230 Wintoki's findings provide indirect

support for the proposition that SOX adversely impacted innovative firms

for which relatively less independent board members is the optimalgovernance structure.

224. Zahra, supra note 68, at 1718; see also Munari & Sobrero, supra note 10, at 20("[linside directors, who actively participate in the operations of the company, are more andbetter informed and, consequently, should be more competent in assessing the strategicdesirability of decisions and their potential consequences in the short or in the long run.").

225. See Lacetera, supra note 100, at 38 (arguing that inside directors enhanceinnovation because they are directly and continuously involved with the company and alsonoting that "granting insiders strategic decision power is said by most studies to be apowerful incentive to share knowledge and competencies").

226. Zahra, supra note 68, at 1718; see also supra Part I.B.227. See Lacetera, supra note 100, at 36; Lassen et al., supra note 12, at 368; Teece et

al., supra note 81, at 521 (noting that "decentralization and local autonomy" facilitate afirm's ability to reconfigure in response to rapidly changing environments).

228. See also Linck et al., supra note 94, at 311 (noting prior research suggesting that "itis not optimal for firms with high information asymmetry to invite monitoring fromindependent directors because it is costly for the firms to transfer firm specific informationto outsiders").

229. M. Babajide Wintoki, Corporate Boards and Firm Value: The Effects of theSarbanes-Oxley Act and the 2002 Exchange Listing Requirements, 13 J. CORP. FIN. 229,243, 246-47 (2007).

230. Id. at 239, 243.


Furthermore, empirical studies largely find a positive correlationbetween the ratio of inside directors and innovation or related activity. In a1996 survey-based study of 127 Fortune 500 corporations, Zahra found thathaving more outside directors was negatively correlated with innovationand strategic renewal.23' Other studies have also observed a correlationbetween R&D spending and the presence of more insider directors.Baysinger et al. found that the percentage of inside directors on a boardwas positively correlated with R&D spending in a representative sample of

232Fortune 500 companies.More recent studies, after the movement toward board independence,

also find a correlation between inside directors and factors which may beproxies for innovation, and attribute this finding to the proposition thatfirms efficiently adapt to higher monitoring costs by choosing moreinsiders to serve as directors.233 Based upon a 1992 to 2001 sample of8,165 observations of public companies, Coles et al. found some evidencethat R&D intensive companies have a greater representation of insiders ontheir boards, reflecting their dependence upon firm-specific knowledgepossessed by inside directors.234 Using a sample of 6,931 public companiesobserved from 1990 to 2004, Linck et al. also found that public companieswith higher monitoring costs had less independent boards.235 However,Link et al. found that higher R&D spending was generally correlated with amore independent board,236 as did Boone et al. based on their study of

2371,019 firms during their first 10 years after going public. Yet, whenisolating R&D intensive companies, Coles et al. found that firm valueincreases with a greater proportion of inside directors. They estimated thatreplacing one outside director with one insider on a ten-member boardincreased shareholder wealth by $263 million in a sample of companies

231. Zahra, supra note 68, at 1725-32.232. Barry D. Baysinger et al., Effects of Board and Ownership Structure on Corporate

R&D Strategy, 34 ACAD. MGMT. J. 205, 207-09 (1991); see also Charles W.L. Hill & ScottA. Snell, External Control, Corporate Strategy, and Firm Performance in Research-Intensive Industries, 9 STRATEGIC MGMT. J. 577, 588 (1988) (finding a significant positivecorrelation between concentrated stock-ownership and R&D spending in 94 research-intensive Fortune 500 companies).

233. Boone et al., supra note 95, at 70-71 (describing the "monitoring hypothesis" in thecontext of reviewing empirical studies on board size, independence and firmcharacteristics).

234. Jeffrey L. Coles et al., Boards: Does One Size Fit All?, 87 J. FIN. ECON 329, 346(2008) (noting that their three-stage least squares regression results "indicate that high-R&Dfirms have a higher insider fraction" on their boards).

235. Linck et al., supra note 94, at 320, 326.236. Id.237. See Boone et al., supra note 95, at 84-86, 90 (estimating that a "one-standard-

deviation increase in the R&D measure predicts a 1.9 percentage point increase in theproportion of independent directors").

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with a median annual sales of $1.8 billion.238 These results on R&Dspending and board composition support the proposition, developed in PartII.C, that a greater proportion of insiders facilitates valuable R&D ininnovative companies whereas, in non-innovative companies, R&Dspending may require greater outside monitoring to guard againstopportunism and optimize its value to the company.239

In addition, based on a sample of 81 public companies that continuallyoperated from 1935 to 2000, Lehn et al. found that independence wasnegatively correlated to growth opportunities where firms operated inmarkets with frequent technological change and rapidly changing prices. 240

Lehn et al. interpreted their finding as demonstrating that companies likeGenentech, which are heavily dependent upon knowledge utilization andflexibility, benefit from the increased presence of insiders.241

Zahra found that stock ownership by outside directors contributes toentrepreneurship, which is consistent with the proposition that givingdirectors incentives to monitor and promote entrepreneurship will facilitatethat activity.242 However, Zahra noted that stock ownership by outsidedirectors can only go so far to facilitate innovation because "the lack ofaccess to information on corporate entrepreneurship may continue tofrustrate even those outside directors who own relatively large blocks ofcorporate stock., 243 This finding underscores the importance ofknowledge-utilization for successful innovation. While stock ownership byoutside directors may increase incentives to be entrepreneurial, incentivesare no substitute for the superior knowledge possessed by inside directors.By limiting the knowledge of the corporation's operations, directorindependence may be a structural barrier to innovative activities anddecision-making.

Finally, innovative firms benefit from relatively smaller boards. Onereason for this is that the high cost of monitoring for innovation activities

238. Coles et al., supra note 234, at 344. Coles et al. found no relation between firmvalue and R&D spending for low-R&D companies. Id.

239. For the potential of R&D spending to give rise to managerial opportunism, seesupra note 128 and accompanying text.

240. Kenneth Lehn et al., Determinants of the Size and Structure of Corporate Boards:1935-2000 10-12, 18, 20-21, 25 (Sept. 2004) (unpublished research paper, on file withUniversity of Pittsburgh, Katz Graduate School of Business), available athttp://www.cepr.org/meets/wkcn/5/5514/papers/ZHAO.pdf.

241. Id. at26.242. Zahra, supra note 68, at 1728; see also Munari & Sobrero, supra note 10, at 21

(stating that Zahra's study indicates that insiders control is more conducive to innovation).In a study of Asian firms, Hung and Mondejar also found that a preference for innovativerisk-taking was positively correlated with share ownership by directors. Humphry Hung &Reuben Mondejar, Corporate Directors and Entrepreneurial Innovation: An Empirical

Study, 14 J. ENTREPRENEURSHIP 117, 125 (2005).243. Zahra, supra note 68, at 1729.


rises in proportion to board size. 2" Management scholars find that largergroups suffer from communication and coordination problems.2 45 Thesedeficiencies may be particularly acute for innovation activities that relyupon communication of knowledge and coordination of interdependentactivities. Supporting this proposition are studies by Boone et al. andCheng which found that board size is negatively correlated with R&Dexpenditures across a broad range of public companies,246 and a study byLinck et al. finding that public companies with high monitoring andadvising costs-characteristics typical of innovative companies-havesmaller boards.2 47 Importantly, no studies have found that R&D intensity,high monitoring costs, or any other proxy for innovation correlates withlarger boards.

In sum, the empirical corporate governance literature suggests that asignificant number of innovative public companies maximize their value toshareholders with relatively less independent and smaller boards.Innovation activities have higher monitoring costs, and the studies findingthat firms with higher monitoring costs tend to have more inside directorsand smaller boards are consistent with the proposition that innovation isfacilitated by proximate, inside monitoring. To the extent SOX increasedthe independence and size of innovative companies' boards beyond theiroptimal levels, SOX may have undermined the ability and propensity ofsuch companies to innovate.

D. Increased Director and Manager Turnover

Maintaining a commitment to long-term investment projects suggeststhat there is an optimal level of decision maker tenure and turnover. On theone hand, long-term commitments will likely be undermined if strategicdecision makers leave the corporation before projects are completed.Successful innovation requires the development of firm-specific knowledgeand skills over a substantial period of time; this implies that innovationmay be lower in corporations where either short tenure or excessiveturnover (or possibly both) undermine and interfere with the long-termcommitments and planning required for innovation. Because successfulinnovation often requires quick execution,2 48 innovation is less likely tosucceed where high turnover leads a company to delay implementing an

244. Linck et al., supra note 94, at 311.245. Linck et al., supra note 165, at 24.246. Boone et al., supra note 95, at 69 (estimating that "a one-standard-deviation

increase in either R&D intensity or return variance predicts a decrease in board size by 0.25members"); Shijun Cheng, Board Size and the Variability of Corporate Performance, 87 J.FIN. ECON. 157, 163 (2008).

247. Linck et al., supra note 94, at 320, 326.248. See Andrew et al., supra note 31, at 17-19.

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1002 U. PA. JOURNAL OF BuSrNESS AND EMPLOYMENT LAW [Vol. 10:4

innovation project until a new manager is integrated into the company. Onthe other hand, directors and managers insulated from the market forcorporate control, or otherwise able to secure excessive tenure, may be lessreluctant to innovate, thus resulting in organizational inertia.240

Empirical research demonstrates that the post-SOX increase inburdens and liabilities has substantially increased turnover among keycorporate personnel. Post-SOX, there has been a significant increase inturnover among CEOs, CFOs, and directors (although turnover rates maybe decreasing and not all increases are attributable to SOX).2 50 Althoughfew empirical studies measure the relationship between director ormanagement turnover and innovation, the research generally suggests thatthe higher, SOX-induced turnover rates are not optimal for innovation. Astudy of post-IPO high-tech medical instrument corporations by YaseminKor provides mixed but suggestive results. Kor found that R&D spendingdecreased as top manager's tenure increased, indicating that newermanagers had incentives to take higher risks than the more established,senior managers. 21 This may indicate that SOX increases innovationinsofar as it has the effect of bringing in new managers willing to take onmore R&D spending or other risky activities. However, Kor also foundthat R&D spending was correlated to shared, team-specific, experience bymanagers, suggesting that risky R&D investments flourish in conditionswhere there is shared understanding and trust.252 Thus, innovation may beundermined by bringing in new managers because shared understandingand trust take time to establish. Kor also found an association betweenlower R&D spending and more outsiders on boards and longer

249. See, e.g., Shelley S. Gordon et al., Convergence Versus Strategic Reorientation:The Antecedents of Fast-Paced Organizational Change, 26 J. MGMT. 911, 915, 918 (2000).

250. See RUSSELL REYNOLDS ASSOCIATES, FINANCIAL OFFICERS' TURNOVER: 2007STUDY 1 (noting that after SOX, CFO, controller and treasurer "turnover has increaseddramatically"); Dan R. Dalton & Catherine M. Dalton, Sarbanes-Oxley and the Guidelinesof the Listing Exchanges: What Have We Wrought?, 50 Bus. HORIZONS 93, 95-96 (2007)(discussing turnover and instability with boards of directors and CEOs); Telis Demos,Doesn't Anyone Want to Be a CFO Anymore?, CNNMONEY.COM, Jan. 22, 2007,http://money.cnn.com/2007/01/22/magazines/fortune/CFO-nopain.fortune/index.htm(reporting that public "[c]ompanies with a market cap of at least $1 billion changed CFOsthree times more often in 2005 than in 2002" and that "among public companies of all sizes,CFO exits increased from 1,867 in 2005 to 2,302 in 2006."); see also DELOITTE, How CFOSCAN THRIVE UNDER THE PRESSURE (2008) (recognizing the increased demands placed onCFOs); Linck et al., supra note 165, at 29-30 (discussing the effects of the Sarbanes-OxleyAct on directors and boards and the associated risks and workloads).

251. Yasemin Y. Kor, Direct and Interaction Effects of Top Management Team andBoard Compositions on R&D Investment Strategy, 27 STRATEGIC MGMT. J. 1081, 1089,1093 (2006) (exploring the varying compositions of board outsiders and top managementteams and how those different combinations effect the intensity of R&D investment).

252. Id. at 1089, 1093.


management tenure. 253 Kor interpreted this finding as evidence thatoutsider boards bring gamesmanship and conflict into a corporation, whichhas the effect of reducing R&D spending.254 This finding also supports theproposition that corporations that rely on proximate inside monitors arebetter equipped to steer investment projects toward risky innovationprojects than corporations that rely on outside monitors.

In addition, some studies have reviewed the impact of tenure orturnover on changes in strategic reorientation, which may be a proxy forinnovation insofar as new products, methods, or forms of organizationresult from changes in strategy. A study by Wiersema and Bentel foundthat longer tenure by top management, including the CEO, was correlatedwith more changes in strategy,2 55 and Gordon et al. found that companieswith higher turnover of top managers (excluding the CEO) were less likelyto modify strategy.256 These findings suggest that top managers must firstgain substantial knowledge of the company before implementing strategicchanges and that the post-SOX increase in turnover undermines thisprocess to the detriment of innovation. However, Gordon et al. also foundthat companies that changed CEOs were more likely to alter their strategicorientation. 257 This may show that SOX increased changes in strategicreorientation, which facilitated innovation. However, to the extent SOXchanged strategic orientation, it is more likely that SOX caused companiesto hire new CEOs with a strategy that promoted a relatively greater focuson risk management and legal compliance as opposed to innovation. Thislatter interpretation is suggested in the next subsection.

E. Changing Roles of Directors and Officers

Directors and top-level managers are responsible for engaging ininnovation-supporting activities like strategic entrepreneurship. Thisincludes strategic monitoring, where directors evaluate management andtop-level managers evaluate subordinates. Generally, the allocation ofcompany time to established projects or routines occurs at the expense oftime that could have been devoted to innovation.258 Moreover, individuals

259possess limited attention spans that they can devote to innovation.

253. Id. at 1091, 1094.254. Id. at 1087-88.255. Margarethe F. Wiersema & Karen A. Bantel, Top Management Team Demography

and Corporate Strategic Change, 35 ACAD. MGMT. J. 91, 113 (1992).256. See Gordon et al., supra note 249, at 933.257. See id.258. See Stieglitz & Heine, supra note 81, at 7 (suggesting that there is "a fundamental

trade-off between the creation and use of assets ... because the creation of new assets getsin the way of an efficient use of existing resources").

259. See Gifford, supra note 59, at 125-26.

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Evidence suggests that the new burdens SOX places on decision makersdistract from innovation-supporting activities like strategicentrepreneurship and strategic monitoring. Instead, directors and top-levelmanagement focus a greater amount of their attention on current activitiesthat relate to regulatory compliance.

At the executive level, one survey finds that CFOs have shifted theirattention away from strategy and increased their focus on regulatorycompliance and short-term risk management.26 In addition, a survey byFinancial Executives International found that large public companies, suchas those with greater than $700 million in revenue, spent an average of9,700 hours on internal control compliance, not including the hours spentby internal information technology and internal audit staff professionals.26" 'It is likely that managers responsible for formulating and executingcompany strategy and other innovation-facilitating activities accounted fora portion of those 9,700 hours, thereby allocating less time to strategy andinnovation activities. Furthermore, requiring management to sign and beresponsible for financial statement sub-certifications has likely shiftedmanagement's time and attention to financial reporting and away frominnovation activities.

At the director level, an April 2006 survey of directors and managersby Ernst & Young ("E&Y") found that "[n]ew regulation-in many casesimposing detailed public disclosure with criminal penalties for directorswho sign off on false or misleading information-is focusing the attentionof the board on monitoring and managing risk as never before., 262 TheE&Y survey found that boards have allocated more resources to addressrisk management issues, including establishing a "growing number of riskcommittees. 263 Regulatory and compliance risk was identified as theprimary cause of increases in overall risk and as the highest priority for riskmanagement. 264 The survey also found that the increase in risk "has calledfor more effort and attention from board members. 265 Independent boardmembers revealed that post-SOX their role shifted from providing strategicadvice to management to establishing and maintaining risk managementprocesses.266 The E&Y survey also noted the potential tension between

260. RUSSELL REYNOLDS ASSOCIATES supra note 250, at 1-3 ("Since the introduction ofSarbanes-Oxley... the role of the CFO has changed from a strategic role to one that carriesmuch more risk and liability than in previous years. . .As the Sarbanes-Oxley dust issettling, a new breed of CFO is emerging: a regulatory expert, with the ability to extendknowledge into accounting, strategy and communications.").

261. FIN. EXECUTIVES INT'L, supra note 186, at 6, 14.262. ERNST & YOUNG, supra note 176, at 1 (emphasis added).263. Id.264. Id. at 5, 11, 18.265. Id. at 9.266. Id. at 10.


directors focusing on risk mitigation and top management's responsibilityfor risk-taking.267 Overall, the workload of individual directors hassubstantially increased post-SOX, with audit and nominating/corporategovernance committees meeting more regularly.2 68 Annual directors' feeshave increased every year since the passage of SOX, likely reflecting theincreased workload resulting from change in the law, in addition toincreased director liability.269

To the extent it has any impact, the increase in workload andheightened focus on compliance, especially in the context of increasedturnover rates, likely distracts from and undermines strategic decision-making. There are no studies directly measuring the impact on innovationwhen managers and directors decrease the time they allocate to long-termstrategy and other innovation-facilitating proximate monitoring. Indirectevidence may be found, however, in studies finding that innovationactivities increase when concentrated stockholdings increase the incentivesor ability of shareholders to engage in more proximate monitoring. Thesestudies are consistent with the more general proposition that innovationdecreases when there is less strategic decision making; a decrease whichmay be attributable to decision makers having either less incentives,abilities, or time to spend on innovation.

A 1991 study of 176 Fortune 500 companies by Baysinger et al. founda positive relationship between concentrated ownership among institutionalstockholders and R&D spending, but not in conditions where concentratedownership was maintained by individuals. 270 This result was attributed toinstitutional investors having greater incentives to take an active and long-term strategic role in management as a result of not being able to sell largeshareholdings without a substantial loss. 2 7 1 Francis and Smith foundevidence that corporations with dispersed shareholders innovate less thanthose with concentrated stock ownership among insiders, and also less thancorporations with a large block of shares owned by an outsider. 72 Theyattribute this to the fact that the latter two types of ownership structures

267. Id. at 11.268. Linck et al., supra note 165, at 15-16; see also Adam Plore, Wanted: Board

Members, PORTFOLIO.COM, July 3, 2007, at 4 (reporting directors' work hours haveincreased to 206 from 100 or 150 prior to SOX); Koehn & DelVicchio, supra note 205, at 1(reporting that one study of public companies found that, on average, audit committees metfive times annually in 2002 and seven times annually in 2003 and other studies finding ameeting of nine times annually in 2005).

269. See THOMAS E. HARTMAN & FOLEY & LARDNER LLP, THE COST OF BEING PUBLIC INTHE ERA OF SARBANES-OXLEY 9 (2006) (charting and tabling the amount of fees that werepaid to auditors between 2001 and 2005); Linck et al., supra note 165, at 10-15 (discussingchanges in director's pay).

270. Baysinger et al. supra note 232, at 209.271. Id. at 212-13.272. Francis & Smith, supra note 113, at 408.

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enable monitoring of managers for innovation and reduce costs created bymyopia. 273 Using a sample of 81 firms from 1979-81, Hill and Snell foundevidence that managerial block ownership overcomes, at least to somedegree, management's inherent aversion to long-term, risky R&Dprojects.2 74 More recently, Lee looked at all publicly traded U.S. firmslisted in 1995 and found that, for firms above a threshold of $100 million inR&D investments, an increase in stock ownership concentration amongindividuals and institutions was significantly correlated with an increase inpatents granted. 275 Thus, to the extent SOX distracts decision makers fromengaging in proximate monitoring or other innovation-supporting activities,it may have the same impact as reducing the incentive or ability ofshareholders to engage in proximate monitoring, which empirical studies ofstock concentration suggest causes a reduction in innovation.

IV. CONCLUSION

The foregoing analysis demonstrates that corporate governancestructures have a powerful impact on innovation by public corporations.SOX increased the importance of financial reporting and control, increasedboard independence and size, increased director and manager turnover, andheightened companies' focus on regulatory compliance. The cumulativeimpact of these changes likely undermines the ability of a substantialportion of public companies to utilize knowledge assets, adapt to change,engage in long-term risky projects, and otherwise undertake innovationactivities. Accordingly, SOX likely inhibits growth in the value of sharesheld by investors in innovative companies that would otherwise adopt moredecentralization and place a greater emphasis on strategic control if notsubject to SOX. Consumers and the overall economy are also worse off tothe extent that SOX causes public companies to operate below theirinnovative potential.

Public companies complying with SOX will undoubtedly continue toinnovate and grow, and likely even at a record pace in absolute terms.However, the foregone benefits due to SOX reducing the innovativepotential of public companies are likely to increase, because the importanceof innovation seems to be increasing. Due to intensifying globalcompetition and the decreasing costs of mass communication, rapid

273. Id. at 385.274. Charles W.L. Hill & Scott A. Snell, Effects of Ownership Structure & Control on

Corporate Productivity, 32 ACAD. MGMT. J. 25, 31, 42 (1989); see also Hill & Snell, supranote 232, at 586-87 (finding a significant positive correlation between concentrated stock-ownership by managers and R&D spending in ninety-four research-intensive Fortune 500companies).

275. Lee, supra note 162, at 45.


economic change is ubiquitous. 76 The U.S. economy's increasing relianceon knowledge assets increases the potential value of innovation becauseinnovation is itself a product of learning and utilizing knowledge. Productlife-cycles are also becoming shorter, thereby increasing the importance ofnew product development.277 In response to the increasing importance ofinnovation, managers at companies worldwide consider innovation a topstrategic priority, and plan on sustaining or even increasing the high levelsof assets allocated to innovation activities.2" Accordingly, SOX likelyimposes a large, hidden, and growing cost in the form of foregone benefitsthat could accrue from innovation.

The findings in this Article support a fundamental easing of theburdens of SOX on innovative firms. The most straightforward reform inthis regard is to make voluntary for all public companies those provisionsof SOX that increase outside monitoring and the emphasis on financialcontrol. Other provisions of SOX, such as increased criminal liability,likely have no tangible impact on innovation and therefore are not requiredto be voluntary in order to facilitate innovation. This approach to reform isconsistent with the research findings that corporate governance structurestend to be optimally chosen based upon firm-specific characteristics. Firmsnot choosing to comply with SOX would have that choice reflected in theirfinancial statements, and would likely draw increased attention fromanalysts and shareholder activists for managerial opportunism. Firmselecting to comply with SOX because they benefit from more outsidemonitoring and financial control would also send a signal to financialmarkets. By making the provisions of SOX that interfere with theinnovation process voluntary, innovative companies that benefit fromadopting more proximate monitoring than permitted under the current lawcould thus operate to their full potential.

Critics of making the provisions of SOX that increase objectivemonitoring and financial control voluntary would be correct to state thatsuch a reform may increase the potential for managerial opportunism. The

276. Kuratko & Morris, supra note 28, at 22 ("Today, the business environment isliterally defined in terms of change" such that "the pace and magnitude of change is greaterthan ever before.") (emphasis in original); MORRONI, supra note 19, at 78-79 (noting that"for many firms innovation has become ... increasingly important" because of an increasein uncertainty in the economic environment); see also Lawson & Samson, supra note 18, at378-380 ("The emergence of the knowledge economy, intense global competition andconsiderable technological advance has seen innovation become increasingly central tocompetitiveness .... Today's organisations face an additional challenge-the requirementto innovate, not just occasionally but often, quickly and with a solid success rate.").

277. Richard A. Bettis & Michael A. Hitt, The New Competitive Landscape, 16STRATEGIC MGMT. J. 7, 8 (1995) (recognizing the implications of technological changes onstrategic management).

278. Andrew et al., supra note 31, at 7-8.

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analysis and evidence presented here, however, suggest that investors andconsumers are not better off when companies suffering from relativelyhigher myopia costs are required to adopt structures designed to inhibitopportunism. While making certain provisions of SOX voluntary may leadto more opportunism in innovative companies, the benefits from innovationwould likely more than offset such costs and result in net benefit forinvestors, consumers, and the economy.

houman b. shadab* - university of pennsylvania law school · innovation and corporate governance:...

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